1944 (4) TMI 12 - HC - Income Tax

Summary

Issues Involved:
1. Construction of the agreement.
2. Computation of profits.
3. Deduction of excess profits tax.
4. Application of ordinary commercial practice.
5. Interpretation of specific clauses and schedules in the agreement.

Issue-wise Detailed Analysis:

1. Construction of the Agreement:
The primary issue revolves around the interpretation of a written agreement dated September 27, 1933, between the appellants and the respondents. The agreement involved the sale of the appellants' business, including goodwill, to a new company. The consideration for the goodwill was to be paid in yearly instalments based on the profits of the new company over eight years. The crux of the issue is whether the excess profits tax, introduced by the Finance (No. 2) Act, 1939, should be deducted in computing the profits for the purpose of these instalments.

2. Computation of Profits:
The third schedule of the agreement outlines the "Method of computing profits of the new company." It specifies that the profits should be computed by the auditors of the new company, following ordinary commercial practice, and their computation would be binding on both parties. The schedule also includes provisions for depreciation, interest on share capital, and transactions between associated companies. The pivotal question is whether the profits should be computed before or after deducting excess profits tax.

3. Deduction of Excess Profits Tax:
The enactment of the excess profits tax created a dilemma. If the tax is deducted, the appellants would not receive any payment for the year 1939-40. If it is not deducted, the appellants would be entitled to lb82,502. The joint liquidators of the appellants sought a judicial determination on this matter. Both Farwell, J., and the Court of Appeal concluded that the excess profits tax should be deducted. Lord Greene, M.R., argued that the computation of profits should follow ordinary commercial practice, which includes deducting excess profits tax to ascertain distributable profits.

4. Application of Ordinary Commercial Practice:
Viscount Simon, L.C., disagreed with the Court of Appeal's reasoning, stating that the profits of a trading company should be computed before deducting direct taxation like excess profits tax. He argued that excess profits tax is a tax on profits, similar to income tax, and should not be deducted to arrive at the profits. He emphasized that the primary purpose of a profit and loss account is to ascertain the balance of profit or loss achieved during the year, not to determine the distributable profits.

5. Interpretation of Specific Clauses and Schedules:
Lord Thankerton supported the Court of Appeal's decision, stating that the general principles of ordinary commercial practice referred to the computation of profits for the purpose of ascertaining divisible profits. He argued that the agreement directed the application of general principles used by trading companies, which includes deducting excess profits tax. Lord Russell of Killowen agreed with this view, emphasizing that the auditors' certification of profits should follow ordinary commercial practice, including the deduction of excess profits tax.

Lord Macmillan, however, dissented, arguing that the agreement intended to measure the value of the goodwill based on the business's profitability, not the tax liabilities. He contended that the payment of excess profits tax should not affect the computation of profits for the purpose of the agreement. He emphasized that the agreement excluded income tax and should similarly exclude excess profits tax.

Lord Wright also agreed with the Court of Appeal, stating that the profits for the purpose of the agreement should be computed following ordinary commercial practice, which includes deducting excess profits tax. He argued that the agreement aimed to share the annual profits between the vendors and the company, and the profits should be those available for distribution to shareholders after deducting excess profits tax.

Conclusion:
The majority of the judges concluded that the excess profits tax should be deducted in computing the profits for the purpose of the agreement. They based their decision on the application of ordinary commercial practice and the interpretation of the specific clauses and schedules in the agreement. The appeal was dismissed, and the decision of the Court of Appeal was upheld.