Kerala High Court
Neroth Oil Mills Company Limited vs Commissioner Of Income-Tax on 7 January, 1987
Equivalent citations: [1987]166ITR418(KER)
Author: T. Kochu Thommen
Bench: T. Kochu Thommen
JUDGMENT T. Kochu Thommen, J.
1. The following two questions have been referred to us, at the instance of the assessee, by the Income-tax Appellate Tribunal, Cochin Bench :
" (1) Whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that under the agreement dated January 19, 1973, the assessee had sold import licences for Rs. 3,50,000 which was received by it from the second party on that day ?
(2) If question No. (1) is answered in the negative, whether Rs. 3,29,870 could be considered as income of the assessee for the assessment year 1974-75, the relevant previous year ending December 31, 1973 ? "
2. The assessee is a private limited company carrying on the business of export of sea foods under the name and style " Kerala Food Packers". During the assessment year 1974-75 relevant to the accounting year ending December 31, 1973, the assessee submitted its return for that year disclosing an income of Rs. 5,41,780. On perusal of the books of account of the assessee, the Income-tax Officer found that the assessee had not disclosed a sum of Rs. 3,50,000 which stood credited to the suspense account as security received. According to the assessee, this amount was not received as income, but as security paid to it in terms of an agreement dated January 19, 1973, to which the assessee and two others were parties and in terms of which the assessee transferred 17 licences of the value of Rs. 11,78,109 for a sum of Rs. 3,50,000, being the assessee's profit margin ; and the security amount was to be adjusted towards the said profit margin on receipt of goods by the buyer. Rejecting the assessee's contention, the officer completed the assessment by adding the said sum of Rs. 3,50,000 minus Rs. 20,130 which was allowed as expenses, being commission paid to its agent at Cochin. The assessee appealed against that order and the appeal was allowed by the Appellate Assistant Commissioner. On further appeal by the Revenue, the Tribunal reversed the finding of the Appellate Assistant Commissioner and confirmed that of the Income-tax Officer.
3. Counsel for the appellant-assessee, Shri Kurian, submits that the sum of Rs. 3,50,000 was provided under the agreement for payment to the assessee as its profit margin respecting the goods imported under the licences and such amount was payable only upon actual receipt of goods and sale of the same to the first party in terms of the agreement. A like sum already received by the assessee under the agreement was only a security which was to be adjusted against the profit margin receivable by the assessee upon performance of the contract. Shri Kurian, therefore, submits that the amount received as security was not the income of the assessee, although it was convertible as income upon the subsequent performance of the contract. The contract, he says, was so performed only long past the assessment year in question and it was only then that income arose.
4. We shall now read the relevant portions of the agreement produced an annexure " A" :
" KERALA FOOD PACKERS Post Box No. 66 Alleppey-688 001 (S. India) January 19, 1973 M/s. General Industrial and Finance Corpn., First party 46, Veer Nariman Road, Bombay-1.
M/s. Suresh Trading Co. (Bombay), 46, Veer Second party Nariman Road, 1st Floor, Bombay-1.
Subject: Agreement to import and sell to the first party various items as per Kerala Food Packers Licences and as per Import Policy prevalent at the time of import.
5. At the request of the first party, M/s. Kerala Food Packers, Post Box No. 66, Alleppey, have arranged Letters of Authority in favour of the first party's nominee, M/s. Suresh Trading Co. (Bombay), for Rs. 11,78,109 (Rupees eleven lakhs seventy-eight thousand one hundred and nine only) under our various licences as shown below):
Licence No. and date Value
1. ............
......
2. ............
.....
3. ............
......
17. ............
.....
Total Rs.
11,78,109
2. The second party has agreed to import the goods and hand it over to M/s. Kerala Food Packers after clearance and it is agreed that the entire imported goods so handed over will be sold to the first party by M/s. Kerala Food Packers, adding on to the imported cost including duty, clearing charges, etc., the licence holder's profit margin of Rs. 3,50,000 (Rupees three lakhs and fifty thousand only) plus sales tax and/or other local taxes, if applicable.
3. The second party having agreed to finance the import has paid on his own behalf and on behalf of the first party, the agreed profit margin of Rs. 3,50,000 (Rupees three lakhs and fifty thousand only) in advance as security which amount M/s. Kerala Food Packers will adjust when goods are delivered to the first party and bills thereon made on the first party.
4. If goods are not imported within the validity period of the licences and the L.A. holder causes the licences to be lapsed, M/s. Kerala Food Packers shall appropriate the entire security deposit paid to them as advance.
5. Should the second party import any items under these licences which are against the Import Control Policy, all damages resulting out of that shall be for the account and risk of the first and second parties only."
6. The agreement is styled as a letter addressed by the assessee to the first party and the second party. The goods covered by the licences were to be imported and financed by the second party. On arrival of the goods, the second party would clear the same in the name of the assessee and hand them over to the assessee for sale to the first party for a total consideration which would, in addition to the cost price, include the profit margin, taxes and other charges. The assessee was to receive, on performance of the contract, a sum of Rs. 3,50,000 as its profit margin. On execution of the agreement, the said sum of Rs. 3,50,000 was paid in advance to the assessee as security adjustable against the profit margin. If the second party failed to import the goods within the time stipulated in the licences, the assessee was entitled to appropriate the security amount. The first party and the second party were to be liable and responsible for all damages resulting from import of goods under the licences contrary to the terms of the Import Control Policy. The total value of the licences is shown as Rs. 11,78,109.
7. When the agreement is read as a whole, in the light of the surrounding circumstances, certain facts come into focus. In the first place, the assessee, as found by the Tribunal, was not entitled to sell the licences, as they were obtained by it for its own manufacturing purposes as an actual user and registered exporter. The sale of the licences was, therefore, an illegal transaction. Secondly, although the transaction postulated import of the goods by the second party, for and on behalf of the assessee, and the assessee had agreed to sell the goods to the first party after they were imported, what really happened was an outright sale of the licences by the assessee, or its rights under them, in favour of the second party or its principal. The second party, describing itself as the nominee of the first party, also ostensibly acted as an agent of the assessee, as the licences stood in the assessee's name. The import was financed and carried out by the second party, either as a nominee of the first party or in its own right, and in truth and essence the assessee had no further interest in the goods, except that it was, in terms of the agreement, obliged to co-operate with the second party in importing the goods and handing over the same to the first party, for and on behalf of the second party, for a total consideration which was to include the sum of Rs. 3,50,000 paid by the second party to the assessee as profit margin or security. Whether the second party was itself only a nominee of the first party, or vice versa, is an aspect which we need not pursue for the purpose of this case. Whatever right the assessee had under the licences thus stood transferred to the second party, although illegally, for a total consideration of Rs. 3,50,000 received in advance as "security" to be adjusted against the "profit margin". This so-called security was not to be refundable even if the goods were not imported by the second party during the stipulated period of operation of the licences, or, if, on account of violation of the Import Control Policy, damages became payable. In other words, what was received as security was not repayable, whether there was due performance of the contract or failure of performance of the contract. The fate of the contract or the subsequent events had no bearing on the amount received by the assessee. What was received by it became irretrievably its own money.
8. It is true that the amount is shown in the books as security and credited to the suspense account. But the book entries divorced from the realities of the transaction and surrounding circumstances and opposed to principles of accountancy do not determine the legal nature of the transaction : Sutlej Cotton Mills v. CIT [1979] 116 ITR 1 (SC). The question really is at what point of time the assessee gained absolute control of the amount in question. If it received the amount without an obligation to repay the same, it was its own money and it was its own income : Keshav Mills Ltd. v. CIT [1953] 23 ITR 230 (SC) and E. D. Sassoon and Company Ltd. v. CIT [1954] 26 ITR 27 (SC).
9. Although styled as security, it was in truth and essence nothing short of income. Although paid as an advance and meant to secure the performance of the contract, the fate of the amount, its ultimate destination, was preordained and the result of the contract had no relevance to its true character. Although one step preceded the other, the sum and substance of the composite transaction, as distinguished from its form, was a device to put the assessee at the outset in full and complete command of the money which in its hands was its true income, but camouflaged as a security with a view to deferring the tax. The payment had no other commercial or economic or beneficial object. It lacked any other reality.
10. In understanding the true impact and the legal nature of the transaction embodied in the agreement, it is not enough if the agreement is analysed clause by clause, but it should be examined as a whole with a view to seeing what is the object and the true intent of the parties in entering upon the transaction. We must look at the whole nature and substance of the transaction, as evidenced by the agreement, and not be bound by the mere use of the words. See Helby v. Matthews [1895] AC 471, 475 and Secretary of State in Council of India v. Sir Andrew Scoble [1903] AC 299, 302 (HL).
11. The traditional rules governing the construction of taxing statutes and their application to the affairs of taxpayers may still be applicable in cases not involving tax avoidance or tax deferment schemes : See the observation of Lord Diplock in Carver v. Duncan [1985] 2 WLR 1010, 1013 : See also the rules set out in Owen Thomas Mangin v. Inland Revenue Commissioner [1971] AC 739, 746 : [1971] 2 WLR 39, 42 (PC). Those rules may, however, prove to be insufficient or inappropriate to deal with sham or fraudulent transactions. A new and radical approach is now adopted by courts in India and abroad towards schemes designed to defeat the law and defraud the Revenue. The dictum of Lord Tomlin in Duke of West' master v. IRC [1936] AC 1, 19; 19 TC 490, 520 ; [1935] All ER Rep259, 267 :
" Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be"
12. or of Learned Hand J. of the United States Second Circuit Court of Appeals in Helvering v. Gregory [1934] 69 F 2d 809 :
" Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury"'
13. or of J. C. Shah J. in CIT v. A. Raman & Co. [1968] 67 ITR 11 (SC) (headnote) :
" Avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. A taxpayer may resort to a device to divert the income before it accrues or arises to him. Effectiveness of the device depends not upon considerations of morality, but on the operation of the Income-tax Act. Legislative injunction in taxing statutes may not, except on peril of penalty, be violated, but it may lawfully be circumvented."
14. though long and deeply embedded in tax jurisprudence, is now judicially viewed with disfavour owing to frequent misuse of the doctrine and its evil consequences and is regarded as totally inapplicable to salvage ingenious schemes containing composite transactions devised with a view to tax avoidance or tax deferment.
15. In McDowell & Co. Ltd. v. CTO [1985] 154 ITR 148, 160 (SC), Chinnappa Reddy j. referring to various decisions including those of the House of Lords in W. T. Ramsay Ltd. v. Inland Revenue Commrs. [1981] 2 WLR 449 (HL) and Furniss v. Dawson [1984] 1 All ER 530 (HL), stated:
" We think that the time has come for us to depart from the Westminster principle (IRC v. Duke of Westminster [1936] AC 1; 19 TC 490) as emphatically as the British courts have done and to dissociate ourselves from the observations of Shah J. (CIT v. A. Raman 6- Co. [1968] 67 ITR 11 (SC)) and similar observations made elsewhere. The evil consequences of tax avoidance are manifold...... In our view, the proper way to construe a taxing statute, while considering a device to avoid tax, is not to ask whether the provisions should be construed literally or liberally, nor whether the transaction is not unreal and not prohibited by the statute, but whether the transaction is a device to avoid tax, and whether the transaction is such that the judicial process may accord its approval to it."
16. Lord Wilberforce stated in W. T. Ramsay Ltd. v. Inland Revenue Commrs. [1982] AC 300 (HL) (at pages 324 and 326); [1981] 2 WLR 449, 457 and 459 :
"......They (the Commissioners) are not, under the Westminster's doctrine or any other authority, bound to consider individually each separate step in a composite transaction intended to be carried through as a whole .........While the techniques of tax avoidance progress and are technically improved, the courts are not obliged to stand still. Such immobility must result either in loss of tax, to the prejudice of other taxpayers, or to Parliamentary congestion or (most likely) to both. To force the courts to adopt, in relation to closely integrated situations, a step by step, dissecting, approach which the parties themselves may have negated, would be a denial rather than an affirmation of the true judicial process. In each case the facts must be established, and a legal analysis made: legislation cannot be required or even be desirable to enable the courts to arrive at a conclusion which corresponds with the parties' own intentions."
17. Referring to that case, Lord Fraser of Tullybelton stated in Furniss v. Dawson [1984] 1 All ER 530, 532; [1984] 2 WLR 226 at pages 228 and 229:
" The true principle of the decision in Ramsay was that the fiscal consequences of a preordained series of transactions, intended to operate as such, are generally to be ascertained by considering the result of the series as a whole, and not by dissecting the scheme and considering each individual transaction separately."
18. Referring to Ramsay, Lord Scarman observed in Furniss v. Dawson [1984] 1 All ER 530, 532; [1984] 2 WLR 226 (HL) as follows (at page 230):
" What has been established with certainty by the House in Ramsay's case is that the determination of what does, and what does not, constitute unacceptable tax evasion is a subject suited to development by judicial process."
19. Referring to the words of Lord Diplock in Inland Revenue Commissioners v. Burmah Oil Co. Ltd. [1982] Simon's Tax Cases 30, 32, Lord Scarman continued ([1984] 2 WLR 226 (HL) at page 230):
" These words leave space in the law for the principle enunciated by Lord Tomlin in IRC v. Duke of Westminster [1936] AC 1, 19 ; [1935] All ER Rep 259, 267, that every man is entitled if he can to order his affairs so as to diminish the burden of tax. The limits within which this principle is to operate remain to be probed and determined judicially. Difficult though the task may be for judges, it is one which is beyond the power of the blunt instrument of legislation. Whatever a statute may provide, it has to be interpreted and applied by the courts ; and ultimately it will prove to be in this area of judge-made law that our elusive journey's end will be found."
20. In the same case, Lord Bridge of Harwich emphasised the need to draw a distinction between form and substance in determining the consequences of composite transactions. He said ([1984] 2 WLR 226 (HL) at p. 233):
"......the distinction between form and substance is one which can usefully be drawn in determining the tax consequences of composite transactions and one which will help to free the courts from the shackles which have for so long been thought to be imposed upon them by the Westminster's case."
21. The principle laid down in that case is summarised in the headnote as follows:
" In determining the fiscal consequences of a preplanned tax saving scheme, no distinction was to be made between a series of steps which were followed through by virtue of an arrangement which fell short of a binding contract and a like series of steps which were followed through, because the participants were contractually bound to take each step. Accordingly, where a tax avoidance or tax deferment scheme consisted of a series of prearranged steps, some of which had no commercial purpose other than the avoidance or deferment of tax, liability to tax was to be determined according to the substance of the scheme as a whole and its end result, notwithstanding (a) that the arrangement was non-contractual, or (b) that each particular step had commercial effect or enduring legal consequences, or (c) that the arrangement was not a self-cancelling scheme designed to produce neither a loss nor a gain."
(See also Inland Revenue Commissioners v. Burmah Oil Co. Ltd. [1982] Simon's Tax Cases 30.)
22. In a number of cases, courts in the United States have denied efficacy to tax avoidance or tax deferment schemes or transactions which otherwise lack economic or commercial reality. In Knetsch v. United States [1960] 364 US 361, 366, the Supreme Court characterised a transaction as a sham transaction which did not appreciably affect the taxpayer's beneficial interest and there was nothing of substance to be realised by him from it beyond a tax deduction. Learned Hand J. observed in Gilbert v. Commissioner of Internal Revenue [1957] 248 F 2d 399 :
" The Income Tax Act imposes liabilities upon taxpayers based upon their financial transactions......... If, however, the taxpayer enters into a transaction that does not appreciably affect his beneficial interest except to reduce bis tax, the law will disregard it;......"
23. On a careful consideration of the agreement as a whole, the conclusion that it was an attempt to defer payment of the tax is irresistible. One principal object of the agreement was to avoid payment of the tax in the year in which it was legally payable and to defer the same to a future year. This was an attempt to defeat the law, and no court can countenance it.
24. In the circumstances, we are of the view that the sum of Rs. 3,50,000 admittedly received by the assessee on execution of the agreement dated January 19, 1973, was income received by it in that accounting year ending December 31, 1973. Accordingly, we answer question No. (1) in the affirmative, that is, in favour of the Revenue and against the assessee. ' Consequently, we recast question No. (2) as follows:
"If question No. (1)is answered in the affirmative, whether Rs. 3,29,870 could be considered as income of the assessee for the assessment year 1974-75, the relevant previous year ending December 31, 1973 ? "
25. The second question, so recast, is also answered in the affirmative, that is, in favour of the Revenue and against the assessee.
26. We direct the parties to bear their respective costs in this tax referred case.
27. A copy of this judgment under the seal of the High Court and the signature of the Registrar shall be forwarded to the Income-tax Appellate Tribunal, Cochin Bench.