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Interpretation of section 42(2) of the Income Tax Act - Application of section 42(2) to a resident company carrying on business with non-resident companies - Determination of whether a non-resident carries on business with a resident for tax purposes. Analysis: The judgment by the Bombay High Court, delivered by Chagla (CJ) and Tendolkar, JJ., involved a limited liability company engaged in marine engineering and ship repair, with its entire share capital owned by two British companies. The company had an arrangement to repair ships of the British companies at cost price without charging any profit, resulting in no profit for the resident company. The income tax authorities applied section 42(2) to assess the profit that would have been made and taxed it. The key issue was the application of section 42(2) to this scenario. Section 42(1) deals with income arising from a business connection in India for non-residents, while section 42(2) pertains to residents carrying on business with non-residents where profits might escape taxation due to a close connection. The court emphasized that the essential requirement under section 42(2) is a resident carrying on business in the taxable territories that would ordinarily yield profits, with a close connection to a non-resident. The non-resident need not carry on business in the taxable territories, but rather have a business activity with the resident. The court rejected the argument that an equation between the businesses of the resident and non-resident was necessary for section 42(2) to apply. It clarified that if the non-resident engages in a business activity with the resident, it constitutes carrying on business with each other. The court highlighted the legislative intent to tax the business activity of the resident that would ordinarily yield profits but doesn't due to the connection with the non-resident. Furthermore, the court dismissed the contention that the non-resident's activity must be part of a profit-making scheme for section 42(2) to apply. It reasoned that repairing ships by the non-resident companies was integral to their profit-making scheme of operating seaworthy ships, essential for their business profitability. The court held that the Tribunal erred in concluding that section 42(2) did not apply in this case, directing the Tribunal to determine the quantum in accordance with the provision. Ultimately, the court answered the reference in the affirmative, with the assessee directed to pay costs.
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