Commissioner Of Income-Tax, Madras v. Harveys Ltd., Tuticorin

JUDGMENT

Leach, C.J The assessee company is a private company having been incorporated in British India in May 1933. The capital is Rs. 5,00,000 divided into 5000 shares of Rs. 100 each and all the shares have been issued. The share-holders and their holdings are as follows: (i) the firm of A. and F. Harvey, 3998 shares; (ii) the Madura Mills Co. Ltd., 1000 shares and the Comorin Investment and Trading Co. Ltd., two shares. For the sake of brevity I will refer to the assessee company as “the Company” to the firm of A. and F. Harvey as “the Firm” and to the Madura Mills Co. Ltd., as the “Madura Mills.” The firm consists of three partners, namely, Mr. A. Harvey, Mr. J.C Harvey and the Tuticorin Co. Ltd., the share-holders of which are mostly certain employees of the firm. Mr. A. Harvey and Mr. J.C Harvey are brothers. The profits of the firm are divisible between the partners in the following proportions: Mr. A. Harvey: 63/128; Mr. J.C Harvey: 63/128; and the Tuticorin Co. Ltd.,: 2/128. The capital of the Comorin Investment and Trading Co. Ltd., is divided into 10000 shares of which Mr. A. Harvey and Mr. J.C Harvey hold between them 9999 shares.

In April 1933 it was arranged that on incorporation the Company should purchase for Rs. 15,00,000 the assets of a cotton ginning business owned by Messrs. A. and J.C Harvey as individuals and not as members of the firm. The assets consisted of lands, buildings, plant and machinery. Of the purchase consideration Rs. 4,71,383 was allocated to the lands and buildings, and Rs. 10,28,617 to the plant and machinery. For several years Messrs. A. and J.C Harvey had ginned cotton for the Madura Mills. The rates charged for the years 1930, 1931 and 1932 averaged Rs. 12-8-0 per candy. Before the incorporation of the Company negotiations took place between Messrs. A. and J.C Harvey and the Madura Mills for the conclusion of an arrangement under which the Madura Mills should allot 20,000 shares to the company and as consideration the company should allot to the Madura Mills 1000 shares and enter into a contract under which the company should agree to gin cotton for the Madura Mills at a flat rate of Rs. 8 per candy for a period of ten years from 1st April 1933. An agreement was arrived at on this basis after the incorporation of the company and 1000 of its shares were allotted to the Madura Mills on 24th July 1933. The formal contract with the Madura Mills was executed on 26th August 1933, and the allotment to the company of the 20,000 shares of the Madura Mills duly followed. The Company paid no cash for the assets which it had acquired from Messrs. A. and J.C Harvey. Of the Rs. 15,00,000 stated to be the consideration, Rs. 5,00,000 was satisfied by the issue of shares and the balance of Rs. 10,00,000 by the issue of debentures. On 2nd June 1933 the company passed the following resolution:

“Resolved unanimously that the sum of Rupees 10,00,000 be raised by the issue of two debentures for Rs. 5,00,000 each bearing interest at 7 per cent per annum charged upon its undertaking and all its property whatsoever and wheresoever both present and future including its uncalled capital if any and goodwill in the form now submitted to the meeting and that in consideration of the Finchlay Investments Limited, and the Kochadai Investments Limited, having each paid to the company the sum of Rs. 5,00,000 that the above mentioned two debentures be sealed and issued to the above companies.”

The Finchley Investments Limited and the Kochadai Investments Limited are two private companies registered in Canada and controlled by Messrs. A. and J.C Harvey through their wives. The Finchley Investments Limited has an authorized capital of $50,250, divided into 50 Class A Cumulative Preferred shares of $5 each, and 10,000 Class B shares of $5 each, of which all the Class A shares and 5990 of the Class B shares have been issued. All the Class B shares are held by Mrs. A. Harvey. This company has taken authority to issue debentures to the value of $1,000,000 and has in fact issued $5,99,000, all of which are also held by Mrs. A. Harvey. The Kochadai Investments Limited has an authorized capital of $25,250 made up of 50 Class A Cumulative Preferred shares of $5 each and 5000 Class B shares of $5 each, of which all the Class A shares and 1990 of Class B shares have been issued. Mrs. J.C Harvey is the holder of the 1990 Class B shares. This company has authority to issue debentures to the amount of $500,000. Of these debentures $199,000 have been issued and $6000 of them have been redeemed. The outstanding debentures are all held by Mrs. J.C Harvey. Of the debentures issued by the Finchley Investments Limited the amount of $169,000 was issued on 17th October 1933, and of those issued by the Kochadai Investments Limited a similar amount was issued on 12th October 1933.

On the passing of the resolution, which I have just quoted, two cheques for Rs. 5,00,000 each were drawn by the firm in favour of the company, but it was not intended that they should be presented for payment. In the course of explanations given on behalf of the company in answer to questions put by the income-tax authorities it was stated that the two cheques were issued by the firm on behalf of the Canadian Companies in pursuance of an oral arrangement between Messrs. A. and J.C Harvey on the one side, and the agents of the Canadian Companies on the other with a view to avoiding costly cross remittances. It was also stated that Mrs. J.C Harveys had received Rs. 5,00,000 from the Kochadai Investments Limited and that Mrs. A. Harveys had received an equal sum from the Finchley Investments Limited. It turned out that the payments to these ladies did not represent cash but merely the issue to them of debentures by the Canadian companies. Therefore the position was that instead of the vendors receiving Rs. 10,00,000 in cash the Canadian Companies which they controlled received debentures for this amount and the Canadian Companies in turn issued their own debentures to the wives of the vendors. The fact that the vendors received by this roundabout way debentures in lieu of cash will not affect the legal position if the transaction is a genuine one, but the Income-tax Authorities say that it is not. They contend that the issue of debentures represents an artificial transaction undertaken to give an appearance of reality to the inflation in the value of the assets acquired by the company and a scheme to defeat the payment of income-tax.

It is made abundantly clear by the Commissioner of Income-tax in the statement of the case that the Rs. 15,00,000 representing the purchase consideration is in fact a highly inflated figure. All the assets of the business had been purchased by Messrs. A. and J.C Harvey between the years 1897 and 1931 for about Rs. 10,50,000. The following statement shows the dates of construction of purchase of the various assets, their original cost, their written down value according to the accounts of the firm, and the values placed upon them at the time of the sale to the assessee:

It is not necessary to examine these figures in detail to show that Rs. 15,00,000 was out of all proportion to the real value of the assets. It will be sufficient if attention is drawn to the machinery statement. The press at Sattur was purchased in 1914 for Rs. 101,411-13-2 and 19 years later was sold for Rs. 2,06,250. The gins at Sattur were purchased between 1905 and 1915 for Rs. 1,05,683-14-2 and were sold for Rs. 2,06,250. The press at Dindigul was acquired during the years 1928 and 1929 for Rs. 84,944-13-10, and was also sold for Rs. 2,06,250. The gins at the same place were purchased during these years for Rs. 60,892-10-11 and they were sold for Rs. 2,06,250. The total assets stood in the books of firm at Rs. 5,00,000 and notwithstanding that there must have been considerable depreciation they were passed on to the company at the figure of Rs. 15,00,000. It has not been suggested by the company that the value of the assets had increased owing to special circumstances. On the contrary, it had to be admitted to the Income-tax Authorities that the value of ginning factories had been seriously affected by the depression prevailing in the textile trade. Indication of the extent of depression may be gathered from the fact that a factory built by another company at Sattur at a cost of over Rs. 2,00,000 was acquired by the company in 1934 for Rs. 40,000.

The company was assessed by the Income-tax Officer, Tuticorin for the year 1934-35 on a total income of Rs. 82,643. The previous year was the year ended 31st March 1934 and the assessment was completed on 31st August of that year. In arriving at the figure of Rs. 82,643, the Income-tax Officer allowed a deduction of Rs. 61,130 as interest on the debentures which were issued to the Canadian companies. The true nature of the transaction with those companies had not then been realized, but further investigations carried out by the Income-tax Officer led to the disclosure of the position which I have stated. It was also discovered that the company had not declared any dividend out of the profits of the year ended 31st March 1934 and that out of the total book profits amounting to Rs. 85,225 during the two years ended 31st March 1935 only Rs. 25,000 had been distributed by July 1935. The explanation given on behalf of the company was that the year 1933-34 was the first year of its working and that having regard to the world depression the directors had decided on the ground of prudence not to pay a dividend in respect of that year. Not being satisfied with this explanation and being of the opinion that the real object of not distributing profits was to enable Messrs. A. and J.C Harvey to avoid a large amount of super-tax, the Income-tax Officer asked the Assistant Commissioner to give his approval under S. 23-A(2), Income-tax Act, 1922 to an order being passed that the sum payable as income-tax by the company should not be determined and that the proportionate share of each member in the profits and gains should be included in the total income of the member for the purpose of assessment to tax. After giving the company an opportunity of being heard the Assistant Commissioner passed the order asked for by the Income-tax Officer. The Income-tax Officer then computed the income of the company for the year, 1933-34 which had escaped assessment in 1934-35 at Rs. 7,11,316. This figure included the following major items:

“(a) Rs. 48,149 … depreciation allowed in excess of the original assessment.

(b) Rs. 61,130 … interest on debentures allowed in the original assessment.

(c) Rs. 600,000 … advance received on account of ginning charges.”

The Income-tax Officer regarded the transaction between the company and the Madura Mills as involving a payment on account of ginning charges of Rs. 6,00,000. This figure was arrived at after allowing the company to treat the allotment of 1000 of its shares to the Madura Mills as a capital transaction. The market value of the 20,000 shares of the Madura Mills which the company acquired was Rs. 7,00,000. The 1000 shares of the assessee which the Madura Mills received in exchange in consequence of the arrangement had no market value, but the Income-tax Officer took the nominal value of Rs. 1,00,000 to be their true value. The difference between Rs. 7,00,000 and the Rs. 1,00,000 represented the payment by the Madura Mills to the company on account of ginning charges for the period of ten years. The company appealed to the Assistant Commissioner against this new computation of income and objected to the inclusion of the three items (a), (b) and (c) in the total income. The Assistant Commissioner accepted the Income-tax Officer's computation and dismissed the appeal. The company then applied to the Commissioner of Income-tax for revision of the Assistant Commissioner's order under S. 33 and asked in the alternative that certain questions of law be referred to this Court under S. 66(2). Messrs. A. and F. Harvey also appealed against the order passed under S. 23-A. That appeal is pending but the question of the validity of the order does not arise in the present proceedings. The Commissioner acceded to the request of the company for a reference and has asked the Court to decide the following questions:

“1. Whether the Income-tax authorities were justified in law in going behind the contract for the sale of the assets of the Harvey Brothers to the petitioner company for Rs. 15,00,000?

2. If the answer to the above is in the affirmative, (a) whether there was any material before the Income-tax Authorities to justify their finding that the original cost of those assets to the petitioner Company was not Rs. 15,00,000 and (b) if there was such material was there any material for their finding that the cost of the assets was Rs. 5,00,000?

3. Whether there was any material before the Income-tax Authorities to justify their conclusion that the debenture loan of Rs. 1,00,000 was illusory and colourable and that the interest paid thereon is not therefore allowable as a deduction?

4. Whether the transaction of exchange of the Madura Mills shares with the shares of the petitioner Company is an isolated transaction and of a capital nature?

5. Whether on the facts of the case the difference if any between the values of exchanged shares could be said to be profit in the hands of the petitioner assessable to tax?

6. Whether the Income-tax Authorities were correct in adopting the market-value in respect of the 20000 Madura Mills shares allotted to the petitioners?

7. Whether there was a material before the Income-tax Authorities to justify their finding that the difference in value between the 20000 shares of the shares of the Madura Mills Ltd., received by the petitioners and the 1000 shares of their own Company allotted by the petitioners to the Madura Mills amounted to 600000?”

Question 1.—By virtue of S. 10(2)(vi), Income-tax Act, 1922, an assessee is entitled to an allowance on account of depreciation in respect of buildings, machinery or furniture which belong to him and are used for the purposes of his business. The Commissioner rightly observes that the original cost of any particular asset is entirely a question of fact and like any other question of fact depends upon the evidence produced to prove it. The mere production of documentary evidence showing that the contract has been made for purchasing assets at a certain price does not conclusively establish the correctness of a claim made by an assessee that for the purpose of S. 10(2)(vi) the original cost is the amount shown in the document. I also agree with the statement of the Commissioner that where the circumstances show that an assessee has arranged to put an entirely fictitious price on his assets it is open to the Income-tax Authorities to refuse to accept that price and to ascertain what the true value is.

On behalf of the Company the learned Advocate-General has contended that the Court cannot go behind the contract, and in support of this argument has quoted the decision of the House of Lords in Aron Salomon v. Salomon & Co. (1) but I fail to see what bearing that case has here. A leather merchant and a boot manufacturer sold his business to a limited company which had a nominal capital of 40,000 shares of £ 1 each. Before the incorporation of the Company the vendor entered into a contract with the trustee of the future Company settling the terms upon which the transfer was to be made. One of the conditions was that partpayment might be made to the vendor in debentures of the Company. The memorandum of association was signed by the vendor, his wife, a daughter and four sons all of whom subscribed for one share each. In partpayment of the purchase consideration debentures were issued to the vendor to whom was allotted 20000 shares which were paid for out of the purchase money. The total number of shares issued was 20,007 and with his 20000 shares the vendor had complete control of the company. At the time of the sale the business was solvent, but bad times came and the company was forced to go into liquidation. The question was whether the vendor as the holder of the debentures was entitled to preference over the other creditors of the company. Overruling the Court of Appeal, the House of Lords held that it was not contrary to the true intent and meaning of the Companies Act, 1862, for a trader to sell his business to a limited liability company consisting of himself and the members of his family, the business then being solvent, all the terms of sale being known to and approved by the shareholders, and all the requirements of the Act being complied with. There had been no fraud upon the creditors or shareholders and the liquidator was not entitled to rescission of the contract of purchase.

In the present case the Court is not considering a situation analogous to the situation in Aron Salomon v. Salomon & Co. (1) and it is not considering the provisions of the Companies Act but the provisions of the Income-tax Act. To accept the argument of the learned Advocate-General would mean that where an assessee had placed a fictitious value on his assets he would be entitled to the statutory allowance for depreciation on the fictitious figure and consequently would escape payment of income-tax. Therefore to accept the argument would be to go against the true intent and meaning of the Income-tax Act. As I hold that the Income-tax Authorities have the right to look behind the contract of sale it follows that my answer to the first question is in the affirmative.

Question 2.—I have shown the basis on which the company says that the figure of Rs. 15,00,000 is arrived at and I am of the opinion that there was material to justify the finding of the Income-tax Authorities that the original cost of the assets acquired was hot Rs. 15,00,000. The purchase consideration was the allotment of shares of the face value of Rs. 5,00,000 and debentures of the nominal value of Rs. 10,00,000 but the shares and the debentures had no value beyond the value of the assets acquired. The company adduced no evidence of the value of the assets. It relied entirely on the figure stated in the contract of sale. In these circumstances the Income-tax Authorities took the true value to be the figure at which the assets stood in the books and as this was the only evidence before them I consider that they were justified in their conclusion, especially in view of the age of most of the assets. If the company had placed before the Income-tax Authorities evidence to show that the assets stood in the books of the firm at a lower figure than their true value the position would have been different. But it did not do so and the inference is that it was not in a position to show that the assets were of higher value. I would answer both parts of the second question in the affirmative.

Question 3.—I have already stated the facts relating to the debenture issue and I consider that these facts provide material amply sufficient to justify the conclusion that the debenture loan of Rs. 10,00,000 was illusory and colourable. It follows that in my opinion the interest paid on the debentures is not allowable as a deduction.

Questions 4, 5, 6 and 7.—These questions may be dealt with conveniently together. The learned Advocate-General has contended that the exchange of the shares of the Madura Mills for the shares of the company and the benefit of the ginning contract must be regarded as one transaction and entirely of a capital nature. He has also said that as the Madura Mills has been allowed to treat it as being a transaction of a capital nature the company must be allowed to treat it in the same way. I am unable to accept either of these propositions. The main part of the consideration which the Madura Mills received for its 20000 shares was the benefit to be derived from the ginning contract. For ten years the company has to gin cotton for the Madura Mills at a price far below the market price. I consider that the Income-tax Authorities were justified in regarding the transaction of a capital nature only to the extent of Rs. 1,00,000, represented by the shares of the company allotted to the Madura Mills. The company in return for an immediate gain of Rs. 6,00,000 agreed to reduce its probable annual gains over a period of ten years. In other words instead of getting a probable income of Rs. 6,00,000 spread over ten years it obtained a lump sum payment in one year. Nor do I regard the fact that this gain was not in money but in money's worth, namely shares, makes any difference.

In my opinion the Income-tax Authorities were also justified in taking the value of the 20000 shares which the company received from the Madura Mills to be the market value at the date of the transaction. It has been argued by the learned Advocate-General that to place on the market at once a block of 20000 shares would mean a depression in the price. As the Commissioner has remarked the shares were not put on the market and were not intended to be put on the market. In support of his argument that the answers to these four questions should be in favour of the company, the learned Advocate-General has quoted to us Howley v. Commissioner of Inland Revenue (1), Van Den Berghs Ltd. v. Clark (2), Short Brothers Ltd. v. Commissioners of Inland Revenue (3) and Commissioner of Income-tax v. Shaw Wallace and Co. (4), but I can find no support for him in these judgments.

In Howley v. Commissioner of Inland Revenue the facts were these. In consideration of an advance of £7,000 made by the assessee to a company in 1905, he received debentures of the nominal value of £7,000 repayable after December 1914, by half yearly instalments of £500 and from a director 5600 £1 ordinary shares of which he was to transfer 400 shares on receiving each payment of £500 in respect of the debentures. He was also to receive one-fifth of the profits each year upto December 1914, and thereafter a share of the profits corresponding in effect to the proportion of the debentures remaining unpaid from time to time. The assessee received no share of the profits for the years 1915, 1916 and 1917 until 1920 when he received a sum of £6000 in settlement of what was due to him by way of profits for those years. In May 1921, he was paid £10,000 in full settlement of the liability under the agreement up to December 1921, the prospective date of its termination. The sums of £6000 and £10,000 were assessed to super-tax for the years 1920-21 and 1921-22 respectively as forming part of his total income for the years 1919-20 and 1920-21. It was held that he was entitled under the original contract to have his share of the profits paid to him each year and that for the purpose of computing his income for super-tax the £6,000 and £10,000 must be spread over the years in respect of the profits of which they were paid, subject to the entire exclusion from liability to super-tax of such part of the sum of £10,000 as represented a composition of his right to receive a share of the profits of the year 1921. In the case now before us there was no arrangement by which the payment was to be spread over a period of years. The contract was one under which the company got an immediate gain in consideration of its reducing its charges. It must be regarded as a contract entered into in the ordinary course of its ginning business and nothing else. Van Den Berghs Ltd. v. Clark was a decision of the House of Lords. The facts are even further away from the facts in the present case but an observation of Lord Macmillan has application here, not in favour of but against the argument of the learned Advocate-General. An English company carried on a large business in the manufacture of margarine, another substitute for butter. In 1908 the company entered into an agreement with a Dutch company of rival manufacture under which the two companies undertook to share profits and losses in the proportion which, on an average of five years, the profits of the rival tradings in margarine bore to each other. In 1913 there was an extension of the agreement which was to be prolonged till the end of 1940. The two companies carried on their business separately until the end of 1913. During the last war the agreement could not be observed, but in 1920 a third agreement was entered into by which the former agreements were amended. One of the terms of the amended agreement was that the results of trading in the year 1914, and later years should be ascertained by accountants on each side and that any dispute arising under the agreements should be settled by arbitration. Disputes did arise and there was a submission to arbitration. The arbitration proceedings were however settled on terms by which the agreements were rescinded and the Dutch Company paid the English Company a sum of £4,50,000 as damages. The question was whether the £4,50,000 was in the nature of a capital asset or a receipt of income to be included in the profits of the English Company. It was held that the payment was in the nature of a capital asset. The passage in the judgment of Lord Macmillan which has bearing in the present case is this:

“Now what were the appellants (the English company) giving up? They gave up their whole rights under the agreements for 13 years ahead. These agreements are called in the stated case ‘pooling agreements’, but that is a very inadequate description of them, for they did much more than merely embody a system of pooling and sharing profits. If the appellants were merely receiving in one sum down the aggregate of profits which they would otherwise have received over a series of years the lump sum might be regarded as of the same nature as the ingredients of which it was composed.”

Lord Macmillan's judgment was accepted by all the members of the House of Lords who heard the appeal and therefore we have here authoritative indication, that if a payment represents a lump sum payment of profits which would otherwise be received over a series of years it may be regarded as representing income. The decision in Short Brothers Ltd. v. Commissioners of Inland Revenue was that the compensation paid in cancellation of certain contracts was chargeable to excess profits duty as a receipt of profits in the course of the company's ordinary trade, and must be included in the profits for the accounting period in which it became payable and was in fact paid. This case certainly does not help the company. Commissioner of Income-tax v. Shaw Wallace and Co. was quoted because the Privy Council there said that the word “income” connotes a periodical monetary return coming in with some sort of regularity, or expected regularity, from definite sources. The source is not necessarily one which is expected to be continuously productive, but it must be one whose object is the production of a definite return, excluding anything in the nature of a mere windfall. It cannot be suggested that the allocation of the 20000 shares of the Madura Mills was in the nature of a windfall. The contract fell within the scope of the memorandum of association of the company and it seems to me that the resulting benefit to the company must be classed as income.

A decision which is far more in point is that of Rowlatt J. in Commissioners of Inland Revenue v. North Fleet Coal and Ballast Co. Ltd., . A company owned a chalk quarry and contracted to supply a purchaser with a specified quantity of chalk yearly for ten years. The contract also included in its terms that the quarry company should build a wharf at which the purchaser's ships could load the chalk. As the result of the war of 1914 the agreement was suspended and after the war the purchaser did not wish to take further deliveries. It was then agreed between the quarry company and the purchaser that in consideration of a payment of £900 a year for the remaining four years of the term the purchaser should be relieved of his liability under the contract. Subsequently, the quarry company accepted a lump sum payment of £3,000 in lieu of the four annual payments of £900 and the £3,000 was applied by the quarry company in writing down the cost of the wharf. It was held that the £3,000 was chargeable to excess profits duty as a trading profit of the quarry company and therefore must be included in the profits of the year in which it was agreed to be paid. Rowlatt J. refused to graft a distinction upon the decision of the Court of Appeal in Short Brothers Ltd. v. Commissioners of Inland Revenue . He considered that if a sum represented profits in a new form then that was income and income in the year in which it was received.

The answers which I would give to the four questions are these; No. 4: The arrangement by which a proportion of the shares of the Madura Mills was issued to the company in respect of the ginning contract is not a transaction of a capital nature and the benefit received by the company represents profits received in the year of payment. No. 5. On the facts of the case the difference between the values of the exchanged shares must be allocated to the ginning contract and as such is profit in the hands of the company assessable to the tax. No. 6. The Income-tax Authorities were right in adopting the market value in respect of the 20,000 shares of the Madura Mills allotted to the company. No. 7. There was material before the Income-tax Authorities to justify their finding that the difference between the 20000 shares of the Madura Mills received by the company and the 1000 shares of the company allotted to the Madura Mills amounted to Rs. 6,00,000.

The result is that the Income-tax Authorities have succeeded on all the questions raised and therefore are entitled to their costs, which we fix at Rs. 250.

King J.—I agree.

Krishnaswami Ayyangar, J.—I agree.

Order accordingly.

N.R.R