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Patel Engineering Co. Ltd. v. Commissioner Of Income-Tax (Central), Bombay.
Factual and Procedural Background
This reference arises from a question referred to the High Court by the Income-tax Appellate Tribunal, Bombay Bench "C". The central factual matrix (as stated in the reference) concerns a limited company (the assessee) and assessment years 1963–64 and 1964–65. For 1963–64 the assessee claimed entertainment expenditure of Rs. 35,958; the ITO allowed Rs. 15,557 and disallowed Rs. 20,401. For 1964–65 the assessee claimed Rs. 30,000 for entertainment expenditure and the ITO allowed only Rs. 7,431, disallowing the remainder. The assessee appealed against these disallowances to the Appellate Assistant Commissioner (AAC). The AAC recorded that the ITO had not given reasons in writing for the disallowance but stated orally that he had disallowed part of the entertainment expenses under section 37(2) of the Income-tax Act, 1961. The assessee contended before the AAC that the ITO had misinterpreted s. 37(2) and that a correct interpretation would make the expenditures allowable within the statutory limit. The AAC held that the statutory percentage under s.37(2) should be applied only to the income reflected in the profit and loss account of the assessee-company (i.e., its own business) and should exclude income from joint ventures/partnerships. The assessee appealed to the Income-tax Appellate Tribunal (Tribunal), which agreed with the AAC. The Tribunal referred the question to this Court for determination: whether the percentage allowance under s.37(2) is to be applied to the profits and gains of the assessee's own business only or to the entire business income inclusive of share income from joint venture partnerships.
Legal Issues Presented
- Whether, on the facts and in the circumstances of the case, the percentage of allowance of entertainment expenditure as laid down in section 37(2) of the Income-tax Act, 1961, is to be applied to the profits and gains of the assessee's own business only, or to the entire business income of the assessee inclusive of share income from joint venture partnerships.
Arguments of the Parties
Appellant's Arguments (Assessee)
- The assessee contended before the AAC that the ITO had failed to correctly interpret section 37(2) of the Income-tax Act, 1961.
- The assessee argued that if s.37(2) were correctly interpreted, the claimed entertainment expenses would fall within the allowable limit prescribed by that subsection.
Revenue / ITO's Position
- The ITO disallowed a portion of the entertainment expenditure and (according to the AAC's note of proceedings) stated orally that the disallowance was made under s.37(2).
- The AAC and the Tribunal proceeded on the basis that the ITO's practical position and the departmental view was that the statutory percentage in s.37(2) should be calculated with reference only to the profits and gains of the assessee's own business (i.e., the income reflected in the assessee-company's profit and loss account) and should exclude income received as shares from joint ventures or partnerships.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| Commissioner Of Income Tax, Bihar v. Ramniklal Kothari, [1969] 74 ITR 57 (Supreme Court) | That a partner's share in the profits of a partnership is "profits and gains of business" carried on by him; the income of the partnership is business income, and the partner's share is income from business carried on by the partner. | The Court relied on this authority to hold that income received by the assessee as share of profits from joint venture partnerships constitutes business income of the assessee for the purposes of s.37(2), and therefore must be aggregated with the assessee's wholly-owned business income when computing the ceiling for entertainment expenditure. |
| CIT v. A. Dharma Reddy, [1969] 73 ITR 751 (Supreme Court) | That emphasis in taxation should be on the nature of the business activity rather than the organisational format in which it is carried on; the same business activity, whether carried on individually or in partnership, is to be treated consistently as the same business. | The Court cited these observations to support the view that construction business income derived by the assessee either through wholly-owned operations or through joint ventures/partnerships should be treated as the same business income for applying the percentage limit in s.37(2). |
Court's Reasoning and Analysis
The Court framed the sole substantive issue narrowly: how to compute the limit on entertainment expenditure under s.37(2) — whether the statutory percentage is to be applied to the profits and gains of the assessee's wholly-owned business only or to the assessee's aggregate business income including share income from joint ventures/partnerships.
The Court began by noting the undisputed factual premise (accepted by the AAC and not contested before the High Court) that the entertainment expenses were incurred "wholly and exclusively for the purposes of the business of the assessee-company" (i.e., they fall within s.37(1)). Thus the only question was the method of calculating the ceiling under s.37(2).
The Court examined the language of s.37(2), particularly the expression "the profits and gains of the business" occurring in clauses (i)–(iv). It compared that phraseology with other provisions of the Income-tax Act: s.14 (heads of income) and s.28, noting that s.28 uses the word "any" before "business" while s.37 uses the definite article "the". The Court asked whether the change in phraseology justified reading "the business" as meaning only the assessee's wholly-owned business rather than all business income of the assessee.
The Court then articulated two interpretive principles applicable to s.37(2): (a) s.37(2) is a special limiting provision that prescribes a ceiling on allowable entertainment expenditure for companies and thus must be construed strictly against the department and liberally in favour of the assessee; and (b) where two reasonable interpretations exist under a taxing statute that imposes a limit, the interpretation more beneficial to the assessee ought to be adopted.
Turning to precedent, the Court relied on the Supreme Court's decision in Commissioner of Income Tax, Bihar v. Ramniklal Kothari to establish that a partner's share in partnership profits is "profits and gains of business" carried on by the partner; thus income from a partnership or registered firm is business income of the partner. The Court read this authority to mean that income derived by the assessee-company as share of profits from joint ventures/partnerships is business income of the assessee-company and not a distinct non-business item for purposes of s.37(2).
The Court also cited CIT v. A. Dharma Reddy for the proposition that emphasis must be placed on the nature of the business activity rather than the organizational form; identical or substantially similar business activities carried on alone or jointly should be treated as the same business for tax purposes. Applying that reasoning to the present facts (where both wholly-owned construction business income and share-of-profit income from joint ventures arose from similar construction activities), the Court concluded that both heads are business income of the assessee for the purpose of computing the statutory ceiling under s.37(2).
Concluding the analysis, the Court held that the words "the profits and gains of the business" in s.37(2) cannot be read to exclude income received as shares from joint ventures/partnerships where that income arises from the same or similar business activity carried on by the assessee. The Court therefore ordered the percentage allowance under s.37(2) to be applied to the assessee's entire business income inclusive of share income from joint ventures/partnerships, while expressly excluding dividends, interest on securities, and capital gains from that aggregation (as conceded in the proceedings).
Holding and Implications
Holding: In the case of this assessee and for the two years under consideration the percentage of allowance of entertainment expenditure as laid down in s. 37(2) is to be applied to the entire business income of the assessee inclusive of share income from joint venture partnership.
Direct implications and consequences:
- The statutory ceiling under s.37(2) must be computed by aggregating the assessee's business income from wholly-owned operations and its share of profits from joint ventures/partnerships (for the years in question), because both constitute business income of the assessee for this purpose.
- Income items that are not business income — specifically dividends, interest on securities and capital gains — are to be excluded from the computation of the s.37(2) ceiling (this exclusion was accepted in the proceedings and repeated by the Court).
- The immediate effect for the parties is that the assessee's claimed entertainment expenditures should be measured against the higher aggregated business-income base; accordingly the previously made disallowances (to the extent they were based on applying the limit only to the assessee's wholly-owned business income) will need to be revisited consistent with this ruling.
- The Court ordered that the Commissioner pay the costs of the reference to the assessee.
Broader precedential effect: The opinion rests on interpretation of s.37(2) and on existing Supreme Court authorities cited; the judgment applies those authorities to the facts before the Court. The opinion does not elaborate wider policy consequences beyond the direct effect on the computation for the assessee in the referred years.
S.K Desai, J.:— A short but interesting point arises for determination in this reference in which the following question is referred to us by the Income-tax Appellate Tribunal, Bombay Bench “C”:
“Whether, on the facts and in the circumstances of the case, the percentage of allowance of entertainment expenditure as laid down in section 37(2) of the Income-tax Act, 1961, is to be applied to the profits and gains of the assessee's own business or to the entire business income of the assessee, inclusive of share income from joint venture partnership?”
2. In order to apprecite the arguments urged at the Bar on behalf of the assessee and the revenue, respectively, a few facts may be stated. The assessee is a limited company, and we are concerned with the assessment years 1963–64 and 1964–65. In the former year, the assessee had claimed entertainment expenditure of Rs. 35,958. According to the ITO, the amount in excess of Rs. 15,557 was required to be disallowed, and the same was accordingly disallowed. The amount disallowed came to Rs. 20,401. For the next year, the assessee had claimed entertainment expenditure in the amount of Rs. 30,000. The ITO only allowed the same in the amount of Rs. 7,431. We are concerned in this reference with the two disallowances. It may be pointed Out that the aggrieved assessee carried the matter in appeal to the AAG. One of the items of which complaint was made in the said appeal was as regards the disallowance of the entertainment expenditure. The AAC noted in his order that no reason for the disallowance had been given by the ITO in his order. The ITO had remained present before the AAC, and he was presumably asked orally to indicate the basis of the disallowance, and this is what the AAC has noted in his order for the above assessment years:
“The ITO noticed that the appellant claimed entertainment expenses at Rs. 35,958 and he allowed Rs. 15,557 only out of the total claim. The ITO has not given any reason for the disallowance. Apparently, there seems to be no dispute that the expenses were incurred wholly and exclusively for the purpose of business of the company. The ITO, who was present, stated that he had disallowed a part of the entertainment expenses u/s. 37(2).”
3. On behalf of the assessee, it was contended before the AAC that the ITO had failed to correctly interpret s. 37(2) and that if the section was correctly interpreted, the expenses would be within the allowable limit.
4. In his order, the AAC proceeded to indicate the various heads of income earned by the assessee. The question considered by the AAC then was whether the statutory percentage of the allowable expenditure on entertainment was required to be calculated on the total income of the assessee. It was conceded that if the entire income was to be taken into account, then the actual expenditure claimed on entertainment was certainly below the limit prescribed under s. 37(2). According to the AAC, the statutory provisions made it clear that the income as reflected in the profit and loss account of the appellant-company only should be taken into consideration for measuring the allowable percentage and the income earned by the assessee from joint ventures or partnerships ought not to be taken into account. The AAC noted that the assessee had received shares in joint venture business principally from three sources and if these large amounts were excluded, then the disallowance made by the ITO would be justified.
5. The assessee carried the matter to the Income-tax Appellate Tribunal. The Tribunal found itself in complete agreement with the reasoning of the AAC. In its view, the words “the business”, occurring in s. 37(2), must be interpreted as the assessee's own business. This meant, according to the Tribunal, that the income as reflected in the profit and loss account of the assessee-company should only be considered in measuring the statutory percentage. If the other view which was canvassed by the assessee were to prevail, then, according to the Tribunal, serious anomalies would result. The adoption of the other view would, in the opinion of the Tribunal, defeat the very object of the section in putting a ceiling on the entertainment expenditure as envisaged in the section.
6. Now, the total income of the assessee for the two years under consideration is set out in the statement of the case, and the same is as follows:
“Assessment years 1963–64 1964–65 Rs. Rs. Income from own business: 15,36,081 2,92,572 Share of income from joint venture partnership 45,77,299 48,58,506 Dividends, interest on securities and capital gains 38,992 47,303 Total income 61,52,372 51,98,381”
7. It seems to be the obvious position that the assessee's income from dividends, interest on securities and capital gains for the two years under consideration, namely, Rs. 38,992 and Rs. 47,303, will be required to be excluded. This has not been disputed by Shri Dastur. The question, however, which is required to be seriously considered is whether the limit prescribed by s. 37(2) is to be calculated on the profits and gains of the wholly-owned business of the assessee-company, namely, Rs. 15,36,081 and Rs. 2,92,572, respectively, or whether the share of the income received by the assessee-company from the joint venture partnerships, which income comes to substantial amounts in the two years under consideration, is also to be considered.
8. It is necessary, in our opinion, to set out in the first place the provisions of s. 37 of the I.T Act, 1961. It reads as under:
“37. General.—(1) Any expenditure (not being expenditure of the nature described in sections 30 to 36 and section 80vv and not being in the nature of capital expenditure or personal expenses of the asssesee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head ‘Profits and gains of business or profession’.
(2) Notwithstanding anything contained in sub-section (1), no expenditure in the nature of entertainment expenditure shall be allowed in the case of a company, which exceeds the aggregate amount computed as hereunder:
(i) on the first. Rs. 10,00,000 of the profits and gains of the business (computed before making any allowance under section 33 or section 33a or in respect of entertainment expenditure) at the rate of 1% or Rs. 5,000, whichever is higher; (ii) on the next Rs. 40,00,000 of the profits and gains of the business (computed in the manner aforesaid) at the rate of ½%; (iii) on the next Rs. 1,20,00,000 of the profits and gains of the business (computed in the manner aforesaid) at the rate of ¼% (iv) on the balance of the profits and gains of the business (computed in the manner aforesaid) Nil.”
9. The short question is whether the Tribunal is right in its view that profits and gains of the business must necessarily mean the profits and gains of a business wholly owned by the assessee and exclude necessarily the income of the assessee from joint venture partnerships.
10. Before considering this question it may be pointed out that we are proceeding to answer the question referred to us on the footing that there is no dispute that the entertainment expenses were incurred wholly and exclusively for the purposes of the business of the assessee-company. This has been made clear by the AAC in his order dealing with the disallowance of the entertainment expenditure. Thus, the ITO seems to have conceded and hence accepted that these were expenses covered by s. 37(1) of the I.T Act, 1961. We are thus left in this reference with the limited question of considering how the limit of entertainment expenditure prescribed by s. 37(2) is to be calculated in the instant case.
11. The Tribunal in its order confirming the view of t???e AAC has laid stress in the first place on the expression “the business” which we have in cls. (i), (ii), (iii) and (iv) prescribing the percentages for calculating the limits of allowable entertainment expenditure. It is further to be borne in mind that the same phrase “the business” also occurs in s. 37(1) where we have a provision for allowance of expenditure “laid out or expended wholly and exclusively for the purposes of the business or profession”.
12. Now, s. 14 of the I.T Act, 1961, deals with heads of income, and head “D” deals with profits and gains of business or profession. It is true that the article “the” is not to be found in the said section. Profits and gains of business or profession are further explained by s. 28 of the said Act where it is provided, inter alia, that profits and gains of business or profession will include the profits and gains of any business or profession which was carried on by the assessee at any time during the previous year. What is the significance to be attached to the departure from the phraseology employed in s. 28 where business was prefixed with the word “any” and the substitution of the said word by the word “the” in s. 37? Will this change warrant the view taken by the Tribunal that the business would mean the wholly-owned business of the assessee-company and not its other business income?
13. It has to be borne in mind that s. 37(2) is a special provision for companies, and that special provision is in the nature of prescribing a limit on allowable entertainment expenditure. In other words, such expenditure would be allowed for any other assessee and would be required to be allowed even for a limited company were it not for the limit prescribed. Two consequences must follow once this position is realised. In the first place, the statutory provision must be strictly construed, that is, liberally as far as an assessee is concerned and strictly as far as the department is concerned. In the second place, if two interpretations are possible to be given to the same, then, since it is a provision prescribing a limit or imposing a ceiling on allowable expenditure occurring under a taxing statute, that interpretation is required to be accepted, which is more beneficial to the assessee.
14. It would appear that the very provision has not come up for consideration before any High Court or the Supreme Court. However, in Commissioner Of Income Tax, Bihar v. Ramniklal Kothari , [1969] 74 ITR 57, it has been observed by the Supreme Court that share in the profits of a partnership received by a partner is “Profits and gains of business.” carried on by him. It has been observed further that (p. 59):
“……it is a matter of no moment that the total profits of the partner ship were computed in the manner provided by section 10 of the Income-tax Act and allowances admissible to the partnership in the computation of the profits and gains were taken into account.”
15. The Supreme Court made it clear that the income of the partnership carrying on business is computed initially as business income. Thereafter, the share of the partner in the taxable profits of the registered firm liable to be included in his total income and is “still received as income from business carried on by him”. (Underlining* supplied). In other words, according to the Supreme Court, the business carried on by a firm is business carried on by the partners and profits of the firm are profits earned by all the partners in carrying on the business.
16. Once the correct position is understood, it is required to be held that there is no warrant for reading the words “the business” as implying or meaning “the assessee's own business” and not the share of profits in the partnership business carried on by the assessee along with some other partner, even though the said partnership is a registered firm and thus a separate taxable entity. It is not permissible to give this interpretation to the statutory provision by considering what the object of the section was and whether the same would be defeated or furthered by the interpretation to be put. The words used are “the business”. It would appear from a perusal of the returns and the orders that the assessee earned an income of Rs. 15,36,081 from the construction business which was wholly owned by it (for the assessment year 1963–64), and for the very same year it earned Rs. 45,77,299 as its share of income from joint venture partnership from similar construction work. The latter business, however, was not wholly owned by the assessee but were either partnerships or joint ventures. According to the Supreme Court, as per its observations in Ramniklal Kothari's case, [1969] 74 ITR 57, both these are businesses of the assessee and hence both the incomes must be regarded as its business income. The words occurring in section 37(2)(i), namely, “on the first Rs. 10,00,000 of the profits and gains of business”, cannot be read to include one out of two heads of business income, and in the instant case bearing in mind that the nature of activity is more or less identical, though at different places, the limit will have to be calculated aggregating the two heads of business income for both the years under consideration.
17. In this connection, we may refer to the observations of the Supreme Court in CIT v. A. Dharma Reddy, [1969] 73 ITR 751, where the emphasis appears to be on the nature of the business and not on the organisational set-up in which the same is Carried on. It has been observed by the Supreme Court in that decision that the assessee before it must be regarded as carrying on the business of taking contracts in respect of or dealing in bidi leaves irrespective of whether he did the same individually (hence wholly-owned) or in partnership with someone else. If these observations in A. Dharma Reddy's case are also considered and applied, they would seem to suggest that the assessee was carrying on construction business, although in different set-ups, and the limit prescribed by s. 37(2) of the I.T Act, 1961, would be required to be calculated having reference to all income from that business irrespective of whether a part of that income arose to the assessee from ventures carried on jointly or in partnership with others and a part from a venture wholly carried on by the assessee. We make it clear that we have proceeded to consider the question referred to us on the footing that it is expressly conceded by the ITO that this amount is laid out or expended wholly or exclusively for the purpose of the business of the assessee. It is on that footing which is reflected in the order of the AAC that we have considered the computation of the limit prescribed under s. 37(2) of the I.T Act, 1961. On that express footing the question referred to us is answered as follows:
In the case of this assessee and for the two years under consideration the percentage of allowance of entertainment expenditure as laid down in s. 37(2) is to be applied to the entire business income of the assessee inclusive of share income from joint venture partnership. It is made clear that the dividends, interest on securites and capital gains will be required to be excluded.
18. The Commissioner to pay the costs of the reference to the assessee.
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