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R.N Gumthannavar v. Commissioner Of Income-Tax, Mysore.
Annotated Summary of the Opinion — Somnath Iyer, J.
Factual and Procedural Background
This reference was made by the Income-tax Appellate Tribunal, Bombay Bench “A”, under section 66(1) of the Income-tax Act, 1922, arising from an order of the Income-tax Officer under section 26A refusing registration of the assessee-firm for the assessment year 1961-62.
The facts (as stated in the opinion): a firm of three partners was constituted under a partnership instrument executed on November 27, 1959. The partnership deed provided for profit and loss sharing in the ratio 50:37:13 (clause 5). Clause 2 stated that the partnership was to be deemed to have commenced on November 11, 1959, and that it was a partnership at will. Clause 6 prohibited any partner from withdrawing his share of profits during the first ten years without the consent of the other partners. Clause 9 provided that a partner retiring within the first ten years would not be entitled to any profits (unless other provisions applied). Clause 10 provided for arbitration; clauses 7 and 8 contained ordinary covenants of fidelity and dissolution on death or retirement.
Procedural history: the Income-tax Officer refused registration, holding that clauses 6 and 9 impaired the existence of a partnership in law. The Appellate Assistant Commissioner disagreed and directed registration. The Appellate Tribunal reversed the Assistant Commissioner and agreed with the Income-tax Officer. The Tribunal referred the legal question to the court: whether the firm constituted under the partnership deed dated November 27, 1959, was registrable under section 26A of the Income-tax Act, 1922.
Legal Issues Presented
- Whether the firm constituted under the deed of partnership dated November 27, 1959, was registrable under section 26A of the Indian Income-tax Act, 1922.
Arguments of the Parties
Income-tax Officer's Position
- The Income-tax Officer accepted that the parties had agreed on profit sharing under section 23(5)(b) for allocation of profits, but concluded that clauses 6 and 9 of the partnership deed contained covenants that led to the conclusion that there was, in law, no partnership.
- Specifically, clause 6 (prohibiting withdrawal of profits for the first ten years) and clause 9 (depriving a retiring partner of profits if he left within ten years) were relied upon to infer that partners were not in fact “entitled” to or “actually enjoy” any share in profit.
Appellate Assistant Commissioner's Position
- The Assistant Commissioner held that the instrument did create a firm: profits for each year were ascertained and credited to partners' accounts in accordance with clause 5.
- The Assistant Commissioner viewed the prohibition on distribution in clause 6 as a stability device — intended to accumulate capital and form a reserve — and not as destructive of partnership status.
- He did not refer to the provision in clause 9 that restricted retiring partners' claims to profits.
Appellate Tribunal's View
- The Tribunal agreed with the Income-tax Officer that clauses 6 and 9, taken together, indicated that partners were not entitled to or did not actually enjoy any share in profits, and therefore registration could be refused.
- The Tribunal expressly noted that, although it considered the firm "genuine", it held that the contested covenants nevertheless barred registration.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| In re Bridgewater Navigation Company (quoted from Lindley L.J.) | Holding that carrying undrawn profits to a suspense or reserve account does not change their character or ownership; they remain undrawn profits of the persons to whom they belong and, if not required for the designated purposes, become divisible as undrawn profits. | The court relied on this principle to conclude that a covenant preventing withdrawal of profits for a specified period does not destroy the character of those amounts as profits to which partners are entitled; therefore clause 6 did not negate partnership status. |
Court's Reasoning and Analysis
The court framed the real question as whether, having regard to clauses 6 and 9 of the partnership deed, the instrument created a firm registrable under section 26A. The court's analysis proceeded in these steps:
- Statutory meaning: The word "firm" in section 26A must be given the same meaning as under the Partnership Act (reference to section 2(6B) of the Income-tax Act). The court relied on section 4 of the Partnership Act, which defines "partnership" as a relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Thus, an agreement to share profits is prima facie evidence of a partnership.
- Examination of the deed as a whole: The court examined the instrument: clause 5 recorded agreed shares in profits and losses; clause 2 made the partnership a partnership at will and fixed commencement in the relevant previous year; clause 6 prohibited withdrawal of profits for ten years subject to consent of other partners; clause 9 barred retiring partners within ten years from claiming profits.
- Effect of clause 6 (prohibition on drawing profits): The court held that clause 6 does not negate the partners' agreement to share profits. The profits, although undrawn for ten years, remain the profits of the respective partners and retain their character and ownership as profits. The court relied on the reasoning in In re Bridgewater Navigation Company to support the proposition that setting aside profits for a purpose or to a reserve does not alter ownership or their character as profits.
- Effect of clause 6's consent proviso: The court emphasized the proviso in clause 6 allowing withdrawal with the consent of other partners. That proviso demonstrates that the partners did have a right to the profits (subject to the contractual limitation), and the existence of that right undermines the argument that clause 6 shows no partnership existed.
- Effect of clause 9 (bar on retiring partner's claim to profits within first ten years): The court found clause 9 did not strip the instrument of its character as creating a partnership. It read clause 9 together with clause 6 (consent) and clause 2 (partnership at will). Because the partnership was at will (section 7 of the Partnership Act) and a partner could dissolve the partnership (section 43 of the Partnership Act), a partner who could not obtain consent could secure payment of his share of profits by dissolving the partnership and thereby making his share payable.
- Enforceability left open: The court expressly declined to decide the enforceability of clause 9's covenant, but said that whether or not clause 9 is enforceable, it does not justify concluding that the relationship is not a partnership.
- Conclusion of analysis: On a fair construction of the instrument, the deed constituted a firm as defined by the Partnership Act; the clauses restricting withdrawal of profits did not negate the partners' entitlement and the existence of a partnership. Therefore the firm, having been constituted in the relevant previous year and being otherwise legitimately the subject of an application for registration, was registrable under section 26A.
Holding and Implications
Holding: The court answered the referred question in favour of the assessee: the firm was constituted under the deed dated November 27, 1959, and that that firm was registrable under section 26A of the Indian Income-tax Act, 1922.
The court awarded costs: the Commissioner will pay the costs of the assessee; Advocate's fee Rs. 250.
Implications: The direct consequence is that the firm's registration under section 26A should not be refused on the basis that contractual provisions (such as a temporary prohibition on drawing profits or a retirement-related bar) negate the existence of a partnership. The opinion does not purport to pronounce on the enforceability of the covenant in clause 9; it only holds that, whatever its enforceability, clause 9 (and clause 6) do not negate the relationship of partnership for the purposes of registration under section 26A. The opinion does not set out any broader novel rule beyond applying established principles (including the principle from In re Bridgewater Navigation Company) to these facts.
Note: This summary is prepared strictly from the content of the provided opinion and does not add facts or conclusions not present in that opinion.
Somnath Iyer, J.:— This reference made by the Income-tax Appellate Tribunal, Bombay Bench “A”, under section 66(1) of the Income-tax Act, 1922, has for its source an order made by the Income-tax Officer under section 26A of the Act refusing registration of the assessee-firm for the assessment year 1961-62.
2. The firm, it was said, consisted of three partners and was constituted under the instrument of partnership executed on November 27, 1959. Under the partnership deed, they were entitled to share the profits and bear the losses in the proportion of 50: 37: 13. The Income-tax Officer, who himself had accepted the status of the assessee as a partnership firm by the application of the provisions of section 23(5)(b) and allocated the profits amongst the partners in proportion to the shares specified in the deed of partnership, thought that clauses 6 and 9 of the partnership deed contained covenants which impel the view that there was no partnership in the eye of law. The Appellate Assistant Commissioner however dissented from that view and directed the Income-tax Officer to register the firm. But that order made by him was reversed by the Appellate Tribunal which concurred in the view taken by the Income-tax Officer. The question of law referred to us reads:
“Whether the firm constituted under the deed of partnership dated November 27, 1959, was registrable under section 26A of the Indian Income-tax Act, 1922.”
3. There are ten clauses in the partnership deed. The second clause states that the partnership must be deemed to have commenced on November 11, 1959, and that it shall be a partnership at will. It is clear from this clause that the partnership, if there was one, came into being during the previous year relating to the relevant assessment year. Clause 3 specifies the name and style under which the partnership business has to be carried on and clause 4 provides for the contribution of capital by partners 1 and 2. Clause 5 specifies the shares in the profits and losses and clause 6 provides that no partner shall withdraw, without the consent of other partners, his share of profits during the first ten years. Clauses 7 and 8 contain the usual covenant that each partner shall be just and faithful to the others and that, in the event of the death or retirement of a partner, the partnership shall stand dissolved. Clause 10 provides for arbitration. Clause 9 upon which dependence was placed by the Income-tax Officer and the Appellate Tribunal reads:
“If any partner shall at any time during the subsistence of the partnership be desirous of retiring from the firm, it shall be competent for him so to do, provided always that he shall in such case give at least one calendar month's notice of his intention so to do. However, any partner retiring within the first ten years from the date of its commencement shall not be entitled to any profits.”
4. One thing which emerges very clearly from the orders made by all the three authorities who dealt with the matter is that none of them had any doubt that the firm was a genuine firm. Indeed, in the course of its order, the Tribunal said this:
“In this view of the matter, we think the Income-tax Officer was right in refusing to register the firm and the Appellate Assistant Commissioner fell into an error in thinking that because the firm was genuine and because such profits were designed to secure stability to the partnership business, they did not come in the way of the assessee.”
5. The question formulated by the Appellate Tribunal is not very appropriately worded. What we are asked to decide is whether the firm constituted under the partnership deed dated November 27, 1959, was registrable under section 26A of the Income-tax Act, 1922. If the firm is a genuine firm—and none stated it was not—and it came into being during the previous year to which the assessment relates and an application was made for registration in accordance with law, it is indisputable that its registration cannot be refused. It appears from the question referred to us that the question assumes that the assessee was a firm and that it was constituted under the partnership deed to which the question refers. Since the partnership, if any, constituted under that instrument of partnership came into being during that relevant period and the application was not found defective for any reason, if we should understand the reference made to us too literally, there should be no difficulty in our deciding it in favour of the assessee. But we have no doubt in our mind that the real question referred to us is whether, having regard to clauses 6 and 9 of the instrument of partnership, the assessee is a firm and was registrable under section 26A.
6. Now the word “firm” occurring in section 26A has to be given the same meaning as that which has to be given under the Partnership Act as can be seen from section 2(6B) of the Income-tax Act.
7. Section 4 of the Partnership Act defines “partnership” as the relation between persons, who have agreed to share the profits of a business carried on by all or any of them acting for all. So an agreement to share the profits of a business is prima facie, though not conclusive, indication of the existence of a partnership. But the Income-tax Officer did not think that a partnership came into being. He was of the opinion that the agreement to share profits which clause 5 incorporates has to be read with the other clauses in the instrument and that, when the instrument of partnership is read as a whole, it would emerge that no firm was in fact constituted. He depended principally upon clause 6 which incorporates the covenant that the profits derived from the business, which was intended to be carried on and conducted, could not be shared during the first ten years after the constitution of the firm. It was also said that the same conclusion flows from the 9th clause of the instrument of partnership which provides that, if any partner retired from the firm before the expiry of that period of ten years, he could not claim a share in the profits earned by the business for the period preceding his retirement. The inference drawn by the Appellate Tribunal on the basis of these two provisions in the instrument of partnership was that it could not be said that the partners “were entitled” to or to “actually enjoy” any share in the profit.
8. The Appellate Assistant Commissioner came to the conclusion that there were circumstances from which it was fair to draw the inference that a firm came into being under the instrument of partnership. He pointed out that in the implementation of the 5th clause, which specifies the shares of each partner in the profits and losses, there was an ascertainment of the profits of each year and that such profits were credited to the account of the respective partners. He was of the view that the prohibition against the distribution of the profits for the first ten years was intended to ensure the stability of the firm and the increase of the capital and to constitute some kind of a reserve fund as an insurance against future losses, if any. He did not allude to the provision contained in clause 9 that the partner who retired before the expiry of ten years would not be entitled to claim any profit.
9. On a fair construction of the instrument of partnership, we lean to the view that it constitutes a firm as defined by the Act. The instrument of partnership makes it clear that the partners agreed to share the profits of the business in the proportion specified in the instrument. The fact that no partner would, as of right, be entitled to draw the profits during the first ten years does not mean that there was no agreement to share the profits. All that that clause means is that the profits had to accumulate and should remain to the credit of the partner who was entitled to it. Such a covenant between partners that, for a specified period of time, the profit should not be shared is not inconsistent with the existence of a partnership. The only conclusion flowing from that covenant is that the profits will remain to the credit of the firm without losing their character as profits to which he is entitled under the terms of the instrument of partnership. That that is the correct view to take is clear from In re Bridgewater Navigation Company1, in which Lindley L.J said this:
“Carrying undrawn profits to a suspense account or to a reserve account does not necessarily change their character, still less their ownership; they remain the undrawn profits of those persons to whom they belonged, dedicated, no doubt, to certain purposes and applicable to those purposes, but not otherwise altered in their character or ownership. If the purposes for which such profits are set apart fail, or if the profits are not required for such purposes, they become divisible, not as capital, but as undrawn profits.”
10. So, whatever may be the reason for which the profits remain undrawn and, even if the profits are not drawn because of a covenant that they should not be drawn for a specified period, the profits continue to remain in the firm as the profits to which the respective partner is entitled and he is the owner of those profits. That being the true position, for a period of ten years during which profits could not be drawn by the partners, the profits earned by each partner retain their character as profits and those profits earned as profits and the ownership with respect to those profits are of the partner who has earned them.
11. We are also of the opinion that there is something else in clause 6 which precludes the notion that the partners had not, under the partnership deed the right to share the profits which, if they had, would prima facie be a clear indication that they are partners. The 6th clause which places an embargo on the appropriation of profits during the first ten years does provide that if the other partners consent to the profits being drawn, the partner might draw the profits even during that period. This provision in the clause makes it abundantly clear that in order to enable the partner to draw his profits he has to secure the consent of the other partners and, if he does so, he could draw the profits. That, in our opinion, is what is destructive of the contention that there is anything in the sixth clause which does not entitle the partners to a share in the profits although they have agreed to so share them.
12. Turning to the 9th clause, we do not find anything in it which can take away from the firm the attribute of a firm if it is one. All that it provides is that a partner who retires from the firm during the first ten years would not be entitled to claim a share in the profits earned till then. This clause, in our opinion, has to be read with the 6th clause under which with the consent of the other partners he would be entitled to take his profits when he retires. There is, however, something of greater importance in the second clause of the deed of partnership, which, in effect, makes it possible for the partner, who wishes to retire, to receive his profits by another process. According to the second clause the partnership is a partnership at will as defined by section 7 of the Partnership Act and it is clear from the 43rd section of that Act that a partnership at will is a partnership which can be dissolved at the instance of any one of the partners. So, if a partner who wishes to retire does not secure the consent of the other partners to the payment to him of his share of profits, all that he has to do is to dissolve the partnership in exercise of his right to do so under section 43 of the Partnership Act and, if he does so, his share of the profits would become payable to him.
13. We do not, in this reference, feel called upon to express any opinion upon the enforceable nature of the covenant in the 9th clause but we are however satisfied that, whether it is a good covenant or not, it does not to any extent persuade the view that the relationship constituted under the instrument of partnership is not one of partners. Our answer to the question referred to us is in favour of the assessee and our answer to the question is that a firm was constituted under the deed of partnership dated November 27, 1959, and that that firm was registrable under section 26A of the Indian Income-tax Act, 1922. The Commissioner will pay the costs of the assessee. Advocate's fee Rs. 250.
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