In compliance with the order of the High Court of Judicature at Madras, in C. M. P. Nos. 14053 of 1950 and 14056 of 1050 dated the 25th September, 1951, under section 66(2) of the Indian Income-tax Act, we hereby draw up a statement of the case, agreed to by both the parties, and refer the question of law set out in that order. The Excess Profits Tax reference is consequential.



2. The assessee is a public limited company carrying on the business in the manufacture and sale of yarn. The directors thereof hold 2350 out of 4782 shares and it is a director controlled company. The assessee buys cotton and from it manufactures 40 counts yarn. Its managing agents are Messrs. Kulli Chetti & Bros, . a firm.



3. In respect of 1944-45 assessment year for the previous year ended 31st December, 1943, the books of accounts of the company disclosed a turnover in yarn of Rs. 41, 50, 20

9. On a scrutiny of the sale transactions, it was found that sales thereof to the extent of Rs. 17, 90, 624 were effected to the following three parties :-

(a) S. Kulli Chettiar and Bros., (managing agency

firm) Rs. 9, 98, 364

(b) M. Arulappa Chettiar (one of the directors) " 4, 87, 864

(c) S. Gopalaswami Chettiar & Bros., (wherein

Muthuswami Chettiar, one of the directors,

is a partner) " 3, 04, 400

17, 90, 624

The rates of sales at which the majority of these were effected were much lower than the rates ruling on the dates delivery. Such differences amounted to Rs. 1, 46, 000 as determined by the Income-tax Officer and this computation is not in dispute.



4. The explanation for the aforesaid transactions was furnished by the assessees auditors in their letter dated 27th August, 1944, which reads as follows :-"In respect of sales of yarn to Messrs. Kulli Chettiar & Bros. the company did not get the usual contracts signed except from November, 1943.

There are four letters written by Messrs. S. Kulli Chettiar & Bros., addressed to the company about contracts of yarn; the letters are dated 22nd January, 1943, 25th January, 1943, 18th February, 1943, and 19th February, 194

3. These letters mention the number of bales contracted and the rate per bundle and the month of delivery.

In respect of the sales in 1943, there is only one contract obtained in the usual manner. The date of the contract is 19th November, 194

3. The number of bales contracted is 25 bales and the rate is Rs. 21-12-0.

There is no other evidence about the formation of prices. It is explained that the managing partner, the late S. Mookkan Chettiar of the managing agency firm used to fix the prices. No regular account or record is kept in respect of such fixation of prices. This is explained to be the practice.

All the sales to the managing agency firm and those to directors of the company have been from time to time placed before the board of directors of the company and the board have been duly appraised of the sales.

In the inner portion of the cover of the contract register there are certain notes scribbled which are said to be jottings of the contracts made on the respective dates noted therein. These notes support the sales if properly related.

In the inner portion of the cover of the contract counterfoil book there are certain notes scribbled and these are also said to denote the notes jotted down as and when the managing agents informed the office about the conclusion of the contracts for the sale of yarn."

"In respect of the sale of yarns to Sri S. A. Arulappa Chettiar there are no contracts as is usually obtained. It is explained that the contracts were only oral. In the case of sale to third party, who is a director of the company, the sales were placed before the Board of Directors and they have been appraised of the rates and sales." *

5. The Income-tax Officer found that the letter relied upon by the auditors did not bear the date stamp of the assessee company; they speak only of 137 bales as against 924 bales supplies to Messrs. Kulli Chettiar & Bros., and even though the assessee company had maintained a contract register, the transaction with the aforesaid three parties were not recorded therein, and the scribblings in the contract register which were only for a part of the transaction did not show the dates of sale and delivery and, therefore, there was really no evidence that any prior contracts had been entered into. Three of the directors of the company were examined who deposed that the sales to the aforesaid parties were passed, in the belief that prior contracts existed and because of their confidence in the managing agents, but it they had known that there was no record or other evidence to support the existence of at least the oral contracts, they would never have sanctioned the aforesaid sales. (Copies of their sworn statements are annexed here to as Annexures A1, A2 and A3 and forming part of the case). The Income-tax Officer held that the sales to the aforesaid three parties had not been effected on the basis of any prior contracts nor in the ordinary course of business and as such the sales were not bona fide. He, thereupon valued the bales at the ruling rates of delivery to the aforesaid three parties and added the difference which worked out to Rs. 1, 46, 000 to the total income of the company.

6. Befores the Appellate Assistant Commissioner, it was reiterated that the sales to the aforesaid parties were on the basis of prior oral contracts entered into in the usual course of business and such contracts were placed before the Board of Director, who approved of them and they were recorded in the register of Interest of Directors as required by the Indian Companies Act and the addition was, therefore, improper. The Appellate Assistant Commissioner, however, upheld the addition and dismissed the appeal.

7. Before the Tribunal, an entirely new line of argument was advanced. It was contended that the sales were effected at concessional rates to the aforesaid parties and there was nothing in law which prohibited a merchant effecting sales at concessional rates so long as the rate at which the sale was effected did not fall below the cost of production and there was nothing which made it incumbent upon a merchant to make a profit in every transaction. The Tribunal, for the reasons, inter alia, that the sales at rates lower than the market rates were not bona fide, that they were put through to screen the profits and that the mode or manner in which profits were screened was no concern of the Revenue, upheld the addition of screened profits which sum was not in dispute. The orders of the Tribunal dated 25th February, 1950, and 7th August, 1950, are annexed hereto and form part of the case.



8. The question, as directed, is :-

"Whether, on the facts and circumstances of the case, the addition of Rs. 1, 46, 000 to the assessable income of the company, was correct "

M. Subbaraya Ayyar, for the assessees.

C. S. Rama Rao Sahib, for the Commissioner.

JUDGMENT

RAJAGOPALA AYYANGAR, J. - This is a reference under section 66(1) of the Indian Income-tax Act. The question of law referred for our decision is "whether on the facts and circumstances of the case, the addition of Rs. 1, 46, 000 to the assessable income of the company was correct."

A few facts are necessary to appreciate the point involved in the reference and of these the following are not in controversy.

The assessee is a public limited company engaged in the business of the manufacture and sale of yarn. It is managed by a firm of managing agents by name Kulli Chetti and Brothers. The reference is concerned with assessment year 1944-45, the accounting year being the calendar year 194

3. A scrutiny of the books of account of the company disclosed a turnover of yarn in that year of Rs. 41, 50, 20

9. Out of these it was found that sales to three parties totaling Rs. 17, 90, 624 had been affected at much below the market rates prevailing on the dates of the sale transaction. The three parties in whose favour the sales were effected were :(1) Kulli Chettiar and Brothers (the

managing agency firm) ... Rs. 9, 98, 364

(2) Arulappa Chettiar (one of the

directors of the company) ... Rs. 4, 87, 864

(3) Gopalaswami Chettiar and Brothers

(a firm in which Muthuswami Chettiar,

one of the director of the company,

was a partner) ... Rs. 3, 04, 400

Total ... Rs. 17, 90, 624

The difference between the price at which yarn was sold to these three and the market rates prevailing at the dates of the respective transaction as disclosed by the sales to other parties was computed by the Income-tax Officer at Rs. 1, 46, 000 and this is the figure mentioned in the reference. We might add that there is no dispute about the arithmetical correctness of the computation.

Suspecting the bona fides of these transaction the Income-tax Officer called upon the assessee company to explain how these sales to the three parties so intimately connected with the management of the company came to be effected. The explanation offered was that the sales were effected in pursuance of oral contracts entered into long earlier and that the prices fixed were those ruling on the dates of those oral contracts. The Income-tax Officer examined this explanation in great detail and rejected it as false. This finding of fact has been affirmed by the Appellate Assistant Commissioner on appeal by the assessee and by the Tribunal on further appeal and is now therefore concluded against the assessee.

The entire controversy hinges as to the legal results following on the rejection of the explanation by assessee. The situation might result in three different positions, each with different legal consequences dependant however upon the exact further facts.

One possibility was that these three sets of sales were bogus ones, with the result that no title was intended to pass from the company in favour of the three persons who were shown in its books as purchasers. In such a case these three parties would hod the goods for the company so that the profits which the company derived from the transaction have to be ascertained by ignoring these transaction of sales and computing them, on foot of the prices entered in the books, but on the basis of the prices realised by the three parties to whom they sold the goods purported to be bought by them. This cannot be established without the books of the three parties being examined with a view to discover whether there was any basis for treating the purchasers as name lender for the company, as also for computing the profits of the company which would be based on the prices actually realised by them. Neither the departmental authorities nor the Tribunal conducted any examination on these lines. If they had done so, and reached a finding as above indicated, the case would have approximated to that which was dealt with by the Patna High Court in East Khas Jharia Colliery Co., Ltd. v. Commissioner of Income-tax. It is only necessary to add that on this basis it is not the market price on the day of their sale that would determine the turnover of the assessee but the actual prices realised by the benamidars. The departmental authorities did not proceed on this basis and there is nothing in any of the orders or findings to justify the sales being treated as sham.The second possibility is that the sales were effected by the company at the market rates prevailing on the day of the sale, but that the managing agents defrauded the company of Rs. 1, 46, 000 by falsely entering in the companys books lower figures than what had actually been realised. This would be a case where moneys which had accrued to the assessee were subsequently misappropriated by its management. In such an event the income having accrued to the company the Revenue Authorities would not be concerned as to whether the company has had the benefit of the moneys. We are unable to discover even a trace of any finding of this type in the order of any of the authorities or of the Tribunal. Such a finding could not be reached without an examination of the books of the three parties who had purchased the good from the mills and these books furnishing evidence to show the payment of a larger sum than had been shown in the books of the assessee.

Lastly, the possibility was that the sales had been effected by the managing agents of the company at lower rates than those prevailing in the market in order that they might improperly profit themselves or their friends. It would undoubtedly be a gross fraud on their part but the benefit which these purchasers derived in the shape of concessional sales could on no principle be regarded as the profits of the company on which it could be taxed. The last one is exactly the conclusion which has been reached by the departmental authorities. The Income-tax Officer summarised his conclusions in these terms :

"I am not satisfied that the sales to the managing agents and to the two directors are regular bona fide transactions. They have been shown preferential treatment and allowed concessional rates by the managing agents to the detriment of the company." *

The Appellate Assistant Commissioner set out these very words of the Income-tax Officer and expressed his concurrence with them. He went on to add

"although the directors were not legally bound to mention these favoured transactions which resulted in a loss to a company of Rs. 1, 46, 000 in the Annual Report of the shareholder they were morally bound to disclose them to the shareholders, but they have not specifically done so." *

When the matter came before the Appellate Tribunal, the assessee was not apparently very serious about its contention that the sales were effected in pursuance of oral contracts entered into at a time when the prices noted in the companys books prevailed. It therefore raised the contention that on the findings recorded by the Income-tax Officer and the Appellate Assistant Commissioner the addition of the sum of Rs. 1, 46, 000 to the assessable profits of the company was legally unsustainable. The Tribunal however decided against the assessee by confirming the finding of the lower authorities but stating their reasoning in these terms. They said :

"the directors of the company who are in the fiduciary capacity to trustees should not have allowed somebody to walk away with such large amounts from the coffers of the company. The income has thus been screened off by the mala fide transaction ..... The question whether these were concessional sales and the assessee had a right to market goods at concessional rates does not arise because of our finding that they were not bona fide sales and they were effected to screen off certain profits which would have otherwise been reflected in the companys books." *

Mr. Rama Rao Sahib, learned counsel for the Commissioner of Income-tax, urged upon us that as the Income-tax authorities including the Tribunal had characterised the sale to the three parties as not bona fide it followed as a matter of law that the addition of Rs. 1, 46, 4000 was justified, and that the conclusions of the Tribunal which we have extracted above amounted to a finding of a fact that the sales were sham. It was in this context that he drew our attention to the decision in East Khas Jharia Colliery Co., Ltd. v. Commissioner of Income-tax. We are unable to agree with the learned counsel for the department for two reason. There was no material before the Revenue Authorities for finding the sales to be sham. As we have explained earlier, a conclusion of this nature could not be reached without an examination of the books of the three purchasers as to how this transaction was dealt with in them and the manner in which they had disposed of to profits, and this sort of investigation was never conducted by the department; and further the Tribunal merely confirmed the findings of the lower authorities as is clearly seen from the passage extracted above. Secondly, if the Tribunal had really meant to find that the sales were sham, their direction should have been to add not the Rs. 1, 46, 000 as was done by the lower authorities but by the larger or the smaller figure of profits which resulted from the sales effected by these three parties out of the purchases now in controversy.Learned counsel for the department laid particular stress upon the finding by each one of the authorities that the sales were not bona fide. This however does not carry him far. Each of the three alternative types which we have indicated above into which the sales might fall would be wanting in bona fides and therefore the want of bona fides by itself would not determine whether the Rs. 1, 46, 000 could be added to the income of the assessee. On our above analysis it follows that the finding of the Revenue Authorities is to the effect that the transactions were merely concessional sales effected by the company to the managing agent or his friends in breach of their obligation to the company. Nothing more than the amount calculated at the concessional prices accrued to this company. On this basis though a right might accrue to the company to proceed against its directors or managing agents or whoever was responsible for these sales for reimbursement of the loss caused to it, there can be no addition to the income of the company as has been done by the Revenue Authorities in the present case. The loss it sustained could never become income. In this view, we are clearly of the opinion that the addition of the Rs. 1, 46, 000 to the income of the assessee was unjustified. The answer to the reference will be in these terms.

At the close of the arguments Mr. Rama Rao Sahib invited us to issue a direction under the proviso 2 to sub-section (3) of section 34 of the Indian Income-tax Act to enable the assessments of the three purchasers from the mills being re-opened. His apprehension was that these parties might not have shown the figures as disclosed by the companys books as their purchase price but instead might have entered the ruling prices as on the date of purchase or some figure higher than that found in the companys books. Since in the course of this assessment the books of the three purchasers do not appear to have been examined, we consider this request reasonable and give directions accordingly.As the assessee has succeeded in the reference, he will be entitled to his costs. Counsels fee Rs. 250.

Reference answered accordingly.