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TMI Blog1980 (5) TMI 24X X X X Extracts X X X X X X X X Extracts X X X X ..... h the efforts of the sole distributors. The firm of M/s. Hans Raj Pahwa and Brothers was constituted by a partnership deed dated 26th March, 1960, comprising the following partners, who agreed to share the profits and losses of the firm in equal proportion: (1) Shri Hans Raj representing his HUF. (2) Shri Jagat Singh representing his HUF. (3) Shri Sohan Lal representing his HUF. By a deed of partnership dated 15th February, 1963, Shri Harmohinder Singh, son of Shri Jagat Singh, was taken as a fourth partner and whereas the aforesaid three partners' share in profits and losses was fixed at 20% each, Shri Harmohinder Singh's share was fixed at 16%. By another agreement dated 30th March, 1965, the assessee again appointed M/s. Hans Raj Pahwa and Brothers, Ludhiana, as its sole selling agent for a further period of five years from 1st April, 1965, to 31st March, 1970. The rate of commission was reduced to 3% on all sales made to parties in India by the company direct or through the efforts of the sole selling agents. By a deed of partnership dated 1st April, 1969, there was a change in the constitution of M/s. Hans Raj Pahwa and Brothers, inasmuch as two more persons, na ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... under consideration, the ITO wrote the following note which was also communicated to the assessee along with the copy of the aforesaid assessment order: " Applicability of section 40A(4)(ii) read with the proviso was studied. This section is applicable only where payment exceeding Rs. 72,000 are made to directors or to their relatives who is an employee or a former employee. In this case commission has been paid to M/s. Hans Raj Pahwa and Brothers in which the directors are also partners. However, none of the directors was mere employee during the accounting year relevant to the assessment year 1972-73. This position also appears to be correct in view of the comments made at page 16 of the explanatory note of the relevant Finance Act, 1971. " After the assessment, the ITO wrote a letter dated 29th March, 1973, that in view of the amended s. 40(c) of the Income-tax Act, 1961 (hereinafter called " the Act "), with effect from 1st April, 1972, each of the six partners of M/s. Hans Raj Pahwa and Brothers was not entitled to a remuneration of more than Rs. 72,000 because Sarvshri Hans Raj, Jagat Singh and Sohan Lal were directors of the assessee-company and Sarvshri Harmohinder S ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ered into an agreement with M/s. Hans Raj Pahwa and Brothers, a partnership concern, which undertook to market and sell its products. It was contended that by virtue of the agreement, onerous obligations had been placed on M/s. Hanj Raj Pahwa and Brothers and in consideration of the contractual obligations, commission at 3% on the sales of the company was allowed. It was submitted that while making the assessment for the year 1972-73, the ITO having regard to the legitimate business needs of the company, did not consider that the commission paid was excessive or unreasonable. The assessee further submitted that the amended provisions of s. 40(c) of the Act did not in any way restrict the expenditure, which was incurred for the legitimate business needs of the company and was in no way excessive or unreasonable. It was submitted that the case of the assessee was not covered by the provisions of s. 40(c)(i) of the Act. It was further submitted that the share of profit of four out of six partners of the firm, belonged to, their HUFs and not to the individual directors and the HUFS, as such, could not be called relations of the directors. The Commissioner did not accept the assessee ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ch shall be made at a later stage. In an application made by the revenue, the following questions of law have been referred to this court for its opinion by the Tribunal : " 1. Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the provisions of section 40(c) as amended with effect from 1st April, 1972, by the Finance (No. 2) Act of 1971 did not govern the payment of commission by the assessee to the sole selling agency firm, M/s. Hans Raj Pahwa and Brothers and further that the expenditure on the aforementioned payment of commission did not constitute expenditure of the nature contemplated by section 40(c)(i) of the Income-tax Act, 1961 ? 2. Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in cancelling the order of the Commissioner of Income-tax passed under section 263 of the Income-tax Act, 1961 ? " As regards I.T. Ref. No. 56 of 1979, which pertains to the assessment year 1973-74, the facts given in I.T. Ref. No. 110 of 1977 are similar, and, therefore, the same need not be repeated. At the instance of the Commissioner, the same two questions of law a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ance in respect of any one person referred to in sub-clause (i) shall, in no case, exceed (A) where such expenditure or allowance relates to a period exceeding eleven months comprised in the previous year, the amount of seventy-two thousand rupees; (B) where such expenditure or allowance relates to a period not exceeding eleven months comprised in the previous year, an amount calculated at the rate of six thousand rupees for each month or part thereof comprised in that period : Provided that in a case where such person is also an employee of the company for any period comprised in the previous year, expenditure of the nature referred to in clauses (i), (ii), (iii) and (iv) of the second proviso to clause (a) of sub-section (5) of section 40A shall not be taken into account for the purposes of sub-clause (A) or sub-clause (B), as the case may be. Explanation.-The provisions of this clause shall apply notwithstanding that any amount not to be allowed under this clause is included in the total income of any person referred to in sub-clause (i)." The provisions of s. 40A, sub-s. (1), (2)(a), (b) and sub-s. 5(a) are as follows: " 40A. (1) The provisions of this section sh ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... where the assessee being a company, firm, association of persons or Hindu undivided family, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner or member, has a substantial interest in the business or profession of that person. Explanation.-For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if, (a) in a case where the business or profession is carried on by company, such person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent. of the voting power; and (b) in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent. of the profits of such business or profession... (5)(a) Where the assessee (i) incurs any expenditure which results directly or indirectly in the payment of any salary to an employee or a former employee, or (ii) incurs any expenditure which results directly or ind ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... covered by the provisions of sub-s. (5)(a)(i) of s. 40A. We are called upon to examine whether the payment of commission to a firm which undertook the responsibility of being the sole distributors of the company, is a remuneration or benefit within the terms of the provisions of s. 40(c). As is clear from the facts narrated in the earlier part of the judgment, the firm had partners having specified shares in the firm. It is no doubt true that the partners of the firm, who undertook to act as sole distributors for the sale of products of the company, are directors or their relatives within the meaning of s. 2(41) of the Act, but the question to be determined is whether the payment of the commission falls within the mischief of remuneration or benefit as envisaged under s. 40(c) of the Act. Further, it has to be found that where the expenditure in question is payment by way of remuneration or benefit or amenity to a director or to person who has a substantial interest in the company, or to a relative of the director or such person, as the case may be. As to what is the substantial interest, has been defined in s. 2(32) of the Act. As is clear from the plain language of the section ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... th the company ? The commission includes in the payments by the company to the firm, all expenditure which the firm shall have to incur to discharge its obligations. A profit from the business activity of the partners of the firm, cannot be held to be remuneration paid by the company directly or indirectly to the director or a person who has a substantial interest in the company or a relative of a director or of such person, as the case may be. It is a well-established principle of law that the share of a partner of a firm from the profits of the firm is a share of profits, which is a business activity and the said income has to be assessed under the heading " Income from business". In this view of the matter, the commission paid to the firm by the company certainly is a payment in connection with the business activity of the firm and the receipt of the profits, if any, by the partners of the firm cannot fall within the mischief of s. 40(c). The word " remuneration ", in its ordinary meaning, connotes, "reward, recompense, pay, wages or salary for service rendered ". The commission paid to a firm is in lieu of the services rendered by the firm in its business activity and cannot ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 40(c) under which expenditure incurred by a company on the provision of any remuneration or benefit or amenity to directors, persons who have a substantial interest in the company and their relatives and the expenditure or allowance in respect of any assets of the company which are used by such persons for their own purposes or benefit is not allowed as a deduction to the extent such expenditure or allowance is, in the opinion of the Income-tax Officer, excessive or unreasonable. Under the amendment, the deduction on account of such expenditure or allowance will be further subject to an overall ceiling limit of Rs. 72,000 in respect of any one director or a person who has a substantial interest in the company or a relative of a director or of such person." The speech of the Finance Minister and the note would suggest that the provisions were amended to discourage the payment of high salaries and remunerations to the persons mentioned in the section. There is no indication that the payment of commission made to a firm by a company in discharge of the contractual obligations for the services rendered by the firm in its business activity is also to be covered under s. 40(c) of the A ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... are of profit of the partners of the firm is a share of the HUF and not that of the director in his individual capacity. The view which we are taking finds support from the decision of the Karnataka High Court in T. T. Pvt. Ltd. v. ITO [1980] 121 ITR 551. On similar facts, as in the present case, their Lordships of the Karnataka High Court came to the conclusion that the payment of commission made to the selling agents by a company does not fall within the mischief of s. 40(c) of the Act. It was held that the same would be covered under the provisions of s. 40A(2)(a). We entirely agree with the view taken in T. T. Pvt. Ltd.'s case [1980] 121 1TR 551 (Car). It may be observed that the provisions of s. 40A(2)(a) of the Act are wide enough to cover the cases where payment is made in respect of the expenditure to any person referred in cl. (b) of that section, if the ITO is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, is excessive. Sub ..... X X X X Extracts X X X X X X X X Extracts X X X X
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