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  • Rajagopalan
  • Rajagopala Aiyangar, JJ.
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Smart Summary

Judicial Opinion — Reference under Section 66(1) of the Income-tax Act (Rajagopala Aiyangar, J.)

Factual and Procedural Background

This is a reference under Section 66(1) of the Income-tax Act. The single question of law referred to the court was: “Whether on the facts and circumstances of the case, the addition of Rs. 1,46,000, to the assessable income of the company was correct”?

The assessee is a public limited company engaged in the manufacture and sale of yarn for the accounting year 1943 (assessment year 1944–1945). The company was managed by a managing-agency firm named Kulli Chetti and Brothers.

A scrutiny of the company’s books showed a turnover of Rs. 41,50,209. Sales to three parties totaling Rs. 17,90,624 had been made at prices substantially below market rates. Those three purchasers and the respective sales recorded were:

  • Kulli Chettiar and Brothers (the managing-agency firm): Rs. 9,98,364
  • Arulappa Chettiar (one of the directors): Rs. 4,87,864
  • Gopalaswami Chettiar and Brothers (a firm in which Muthuswami Chettiar, a director, was a partner): Rs. 3,04,400

The Income-tax Officer computed the difference between the prices charged to these three parties and market rates at Rs. 1,46,000; the arithmetic correctness of that computation was not disputed.

The Income-tax Officer doubted the bona fides of these transactions and required an explanation. The company explained the sales resulted from oral contracts entered into earlier and that the prices recorded were the prices fixed on the dates of those oral contracts. The Income-tax Officer rejected that explanation as false; that factual finding was affirmed by the Appellate Assistant Commissioner and later by the Tribunal, and thus is concluded against the assessee.

Legal Issues Presented

  1. Whether, on the facts and circumstances of the case, the addition of Rs. 1,46,000 to the assessable income of the company was correct?
  2. What legal consequences follow from the rejection of the assessee’s explanation that the concessional sales were made under earlier oral contracts — i.e., whether a finding that the sales were not "bona fide" justifies treating the Rs. 1,46,000 as the company's taxable income?

Arguments of the Parties

Assessee's Arguments

  • The company explained that the sales to the three connected parties were made pursuant to oral contracts entered into earlier, and that the prices in the books reflected prices fixed on the dates of those oral contracts.
  • On appeal before the Tribunal the assessee contended that, given the findings recorded by the Income-tax Officer and the Appellate Assistant Commissioner, the addition of Rs. 1,46,000 to the assessable profits was legally unsustainable.

Revenue's Arguments

  • Counsel for the Commissioner (Mr. Rama Rao Sahib) argued that because the Revenue authorities, including the Tribunal, had characterised the sales as not "bona fide", it followed as a matter of law that the addition of Rs. 1,46,000 was justified.
  • The Revenue relied upon a decision of the Patna High Court (East Khas Jharia Colliery Co. Ltd. v. Commissioner of Income-tax) to support the proposition that sham sales can be treated so as to make an addition to the assessee’s income.
  • Further, the Revenue pressed that the repeated finding of want of "bona fides" by each authority was sufficient to sustain the addition.

Table of Precedents Cited

Precedent Rule or Principle Cited For Application by the Court
East Khas Jharia Colliery Co. Ltd. v. Commissioner of Income-tax, B and O, 1943-11-ITR 299 (Pat) (A) Authority dealing with treatment of sham/bogus sales where purchasers are benamidars and the assessee's turnover/profit should be assessed by reference to the prices actually realised by the purchasers on resale (i.e., where sales are a mere façade). The court considered this authority but declined to apply it on the facts. The court held there was no material before the Revenue to justify a finding that the sales were sham because the books of the three purchasers were not examined; further, if the Tribunal had really found the sales to be sham it should have directed an addition based on the profits actually realised by those purchasers rather than the flat Rs. 1,46,000. Consequently the Patna decision was not treated as establishing entitlement to the addition in this case.

Court's Reasoning and Analysis

The court framed the central legal problem as determining the legal consequences of the authorities' rejection of the assessee's explanation. The court proceeded by identifying three distinct factual-legal possibilities consistent with a finding that the transactions lacked bona fides — and it analyzed each possibility against the material before the authorities:

  1. Sales were bogus/sham: The company did not intend to pass title; purchasers were mere name-lenders (benamidars). In that event the goods would still effectively belong to the company and the profits should be computed by reference to the prices actually realised by the purported purchasers when they sold the goods. The court observed that establishing this fact would require examination of the purchasers' books to see how the transactions were recorded and how the purchasers disposed of the goods. No such examination occurred; neither the departmental authorities nor the Tribunal investigated on this basis. The court therefore concluded there was no material to support treating the sales as sham in this technical sense.
  2. Sales were genuine (at market rates) but managing agents misappropriated the excess: Here money accrued to the company and was subsequently misappropriated by management. Again, proving this would require examination of the purchasers' books to show that purchasers had in fact paid higher amounts than recorded in the company's books and that moneys had been diverted. The court found no trace of such a finding by the authorities; no such investigation had been made.
  3. Sales were concessional and intended to benefit managing agents or their friends: The managing agents may have sold to connected parties at lower-than-market rates to benefit themselves or associates. This is a breach of fiduciary duty on the part of managing agents or directors. The court concluded that this is the factual position the authorities had in mind: the company actually received only the concessional amounts recorded in its books; the gap represented a loss to the company caused by agents/directors acting improperly. The court emphasized that such a loss cannot be converted into the company's income for taxation purposes merely because the transactions lacked “bona fides.”

The court rejected the Revenue's submission that the repeated characterization of the transactions as "not bona fide" necessarily supported the Rs. 1,46,000 addition. The court explained that all three alternative factual situations would be "wanting in bona fides" but each yields very different legal consequences for assessment. Therefore, "want of bona fides" without particularized findings and supporting material identifying which factual situation obtained could not justify the chosen mode of addition.

Two further analytical points were pivotal to the court's rejection of the addition:

  • There was no material showing the transactions were sham in the technical sense because the purchasers' books were never examined — an essential step to prove that title had not passed or to compute profits on resale.
  • If the Tribunal had in truth found the sales to be sham (i.e., purchasers were benamidars), the proper approach would have been to compute and add the precise profits realized by those purchasers on resale — not to accept the flat figure of Rs. 1,46,000 fixed by the Income-tax Officer without the requisite inquiry.

On the basis of the material and findings that did exist, the court concluded the authorities had established the third type of situation: the managing agents (or those in control) had given preferential, concessional rates to connected purchasers in breach of their fiduciary obligations, causing a loss to the company. That factual conclusion does not convert the loss into the company’s income; the company’s tax liability must be determined on the amounts actually accruing to it (i.e., the concessional prices recorded), and the company retains a civil remedy against responsible persons for recovery of the loss.

Separately, the court accepted the Revenue's request (made at the hearing) that assessments of the three purchasers be reopened under proviso 2 to sub-section (3) of Section 34 of the Income-tax Act, because the purchasers’ books had not been examined and that examination was necessary to determine whether the purchasers had shown different figures (e.g., market prices realized) in their own records.

Holding and Implications

Holding: The court held that the addition of Rs. 1,46,000 to the assessable income of the company was unjustified.

Implications and direct effects of the decision:

  • The specific addition of Rs. 1,46,000 to the company's assessable income is set aside — the company prevailed on the reference.
  • The court directed that the assessments of the three purchasers be reopened under proviso 2 to sub-section (3) of Section 34 so that their books may be examined (because that inquiry had not previously been undertaken and is necessary to determine whether some other legal mode of assessment is appropriate).
  • The company (assessee) was awarded its costs: counsel’s fee of Rs. 250.
  • No broader legal principle was declared beyond the direct application to the facts: the court emphasized that a mere finding of want of bona fides does not, without further material and careful inquiry, determine that a particular amount should be added to the assessee’s income. The opinion does not purport to lay down a new precedent beyond the factual and analytic conclusions reached in this case.

Disposition: Reference answered in favour of the assessee; the addition of Rs. 1,46,000 was held unjustified and directions were given for reopening assessments of the three purchasers.

Show full summary ...

    Ramalinga Choodambikai Mills Ltd. v. Commissioner Of Income-Tax

    Rajagopala Aiyangar, J.:— This is a reference under Section 66(1) of the Income-tax Act. The question of law referred for our decision is:

    “Whether on the facts and circumstances of the case, the addition of Rs. 1,46,000, to the assessable income of the company was correct”?

    2. A few facts are necessary to appreciate the point involved in the reference and of these the following are not in controversy. The assessee is a Public limited company engaged in the business of the manufacture and sale J of yarn. It is managed by a firm of managing agents by name Kulli Chetti and Rrothers. The reference is concerned with the assessment year 1944-1945, the accounting year being the calendar year 1943.

    3. A scrutiny of the books of account of the company disclosed a turnover of yarn in that year of Rs. 41,50,209. Out of these it was found that sales to three parties totalling Rs. 17,90,624 had been effect ed at much below the market rates prevailing on the dates of the sale transaction. The three parties in whose favour the sales were effected were:

    1. Kulli Chettiar and Rrothers (the managing agency firm) … Rs. 9,98,364 2. Arulappa Chettiar (one of the directors of the company) … 4,87,864 3. Gopalaswami Chettiar and Brothers a firm in which Muthuswami Chettiar, one of the directors of the company was a partner) … 3,04,400 Total Rs. … 17,90,624

    4. The difference between the price at which yarn was sold to these three and the market rates prevailing at the dates of the respective transactions as disclosed by the sales to other parties was computed by the Income-tax Officer at Rs. 1,46,000 and this is the figure mentioned in the reference. We might add that there is no dispute about the arithmetical correctness of the computation.

    5. Suspecting the ‘bona fides’ of these transactions the Income-tax Officer called upon the asses-see-company to explain how these sales to the parties so intimately connected with the management of, the company came to be effected. The explanation offered was that the sales were effected in pursuance of oral contracts entered into long earlier and that the prices fixed were those ruling on the dates of these oral contracts.

    6. The Income-tax Officer examined this explanation in great detail and rejected it as false. This finding of fact has been affirmed by the Appellate Assistant Commissioner on appeal by the assessee and by the Tribunal on further appeal and is now therefore concluded against the assessee.

    7. The entire controversy hinges as to the legal results following on the rejection of the explanation by the assessee. The situation might result in three different positions, each with different legal consequences dependent however upon the exact further facts.

    8. One possibility was that these three acts of sales were bogus ones, with the result that no title was intended to pass from the company in favour of the three persons who were shown in its books as purchasers. In such a case these three parties would hold the goods for the company, so that the profits which the company derived from the transactions have to be ascertained by ignoring these transactions ct sales and computing them, not on foot of the prices entered in the books, but on the basis of the prices realised by the three parties when they sold the goods purported to be bought by them.

    9. This could not be established without the books of the three parties being examined with a view to discover whether there was any basis for treating the purchasers as name lenders for the company, as also for computing the profits of the company which would be based on the prices actually realised by them. Neidier the departmental authorities nor the Tribunal conducted any examination on these lines. If they had done so, and reached a finding as above indicated, the case would have approximated to that which was dealt with by the Patna High Court in — ‘East Khas Jharia Colliery Co. Ltd. v. Commissioner of Income-tax, B and O’, 1943-11-ITR 299 (Pat) (A).

    10. It is only necessary to add that on this basis it is not the market price on the day of their sale that would determine the turnover of the assessee but the actual prices realised by the benamidars. The departmental authorities did not proceed on this basis and there is nothing in any of the orders or findings to justify the sales being treated as sham.

    11. The second possibility is that the sales were effected by the company at the market rates prevailing on the day of the sale, but that the managing agents defrauded the company of Rs. 1,46,000, by falsely entering in the company's books lower figures than what had actually been realised. This would be a case where moneys which had accrued to the assessee were subsequently misappropriated by its management.

    12. In such an event the income having accrued to the company the revenue authorities would not be concerned as to whether the company has had the benefit of the moneys. We are unable to discover even a trace of any finding of this type in the orders of any of the authorities or of the Tribunal. Such a finding could not be reached without an examination of the books of the three parties who had purchased the goods from the Mills and these bodks furnishing evidence to show the payment of a larger sum than had been shown in the books of the asses-see.

    13. Lastly, the possibility was that the sales had been effected by the managing agents of the company at lower rates than those prevailing in the market in order that they might improperly profit themselves or friends. It would undoubtedly be a gross fraud on their part but the benefit which these purchasers derived in the shape of concessional sales could on no principle be regarded as the profits of the company on which it could be taxed.

    14. The last one is exactly the conclusion which has been reached by the departmental authorities-The Income-tax Officer summarised his conclusions in these terms:

    “I am not satisfied that the sales to the managing agents and to the two directors are regular, ‘bona fide’ transactions. They have been shown preferential treatment and allowed concessional rates by the managing agents to the detriment of the company.”

    15. The Appellate Assistant commissioner set out these very words of the Income-tax Officer and expressed his concurrence with them. He went on to add, “although the directors were not legally bound to mention these ‘favoured’ transactions which resulted in a loss to the company of Rs. 1,46,000 in the Annual Report of the share-holders they were morally bound to disclose them to the share-holders, but they have not specifically done so.”

    16. When the matter came before the Appellate Tribunal, the assessee was not apparently very serious about its contention that the sales were effected in pursuance of oral contracts entered into at a time when the prices noted in the company's books prevailed. It therefore raised the contention that on the findings recorded by the Income-tax Officer and the Appellate Assistant Commissioner, the addition of the sum of Rs. 1,46,000 to the assessable profits of the company was legally unsustainable.

    17. The Tribunal however decided against the assessee by confirming the findings of the lower authorities but stating their reasoning in these terms. They said,

    “the directors of the company who are in the fiduciary capacity of trustees should not have allowed somebody to walk away with such large amounts from the coffers of the company….The income has thus been screened off by the ‘mala fide’ transactions ….The question whether these were concessional sales and the assessee had right to market goods at concessional rates does not arise because of our finding that they were not ‘bona fide’ sales and that they were effected to screen off certain profits which would have otherwise reflected in the company's books.”

    18. Mr. Rama Rao Sahib, learned counsel for She Commissioner of Income-tax, urged upon us that as the Income-tax authorities including the Tribunal had characterised the sale to the three parties as not ‘bona fide’, it followed as a matter of law that the addition of Rs. 1,46,000 was justified, and that the conclusions of the Tribunal which we have extracted above amounted to a finding of fact that the sales were sham.

    19. It was in this context that he drew our attention to the decision in 1943-11-I.T.R 299 (Pat) (A). We are unable to agree with the learned counsel for the department for two reasons. There was no material before the Revenue authorities for finding the sales to be sham. As we have explained earlier, a conclusion of this nature could not be reached without an examination of the bonks of the three purchasers as to, how this transaction was dealt with in them and the manner in which they had disposed of the profits, and this sort of investigation was never conducted by the department and further the Tribunal merely confirmed the findings of the lower authorities as is clearly seen from the passage extracted above.

    20. Secondly if the Tribunal had really meant to find that the sales were sham, their direction should, have been to add not the Rs. 1,46,000 as was done-by the lower authorities but by the larger or the smaller figure of profit which resulted from he sales effected by these, three parties out of the purchases now in controversy.

    21. Learned counsel for the department laid; particular stress upon the finding by each one of the authorities that the sales were not ‘bona fide’. This however does not carry him far. Each of the-three alternative types which we have indicated above into which the sales might fall would be.; wanting in ‘bona fides’, and therefore the want of ‘bona fides’ by itself would not determine whether, the Rs. 1,46,000 could be added to the income of the assessee.

    22. On our above analysis, it follows that the finding of the revenue authorities is to the effect that the transactions were merely concessional sales effected by the company to the managing agent or their friends in breach of their obligation to the company. Nothing more than the amount calculated at the concessional prices accrued to the company. On this basis though a right might accrue to the company to proceed against its directors or managing agents or whoever was responsible for these sales for reimbursement of the loss caused to it, there can be no addition to the income of the company as has been done by the revenue authorities in the present case.

    23. The loss sustained could never become income. In this view, we are clearly of the opinion that the addition of the Rs. 1,46,000 to the income of the assessee was unjustified. The answer to the reference will be in these terms.

    24. At the close of the arguments Mr. Rama Rao Sahib invited us to issue a direction under proviso 2 to sub-S. (3) of Section 34 of the Income-tax Act, to enable the assessments of the three purchasers from? the mills being reopened. His apprehension was-, that these parties might not have shown the figures-as disclosed by the company's books as their purchase-price but instead might have entered the ruling: prices as on the date of purchase or some figure-higher than that found in the company's books. Since in the course of this assessment the books of the three assessees do not appear to have been examined, we consider this request reasonable and give directions accordingly. As the assessee has succeeded in the reference, he will be entitled to Ms. costs. Counsel's fee Rs. 250/-.

    H.G.P

    25. Reference answered..

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    Ramalinga Choodambikai Mills Ltd. v. Commissioner Of Income-Tax
    (Apr 18, 1955)