K. M. S. Lakshmanier and Sons v. Commissioner of Income Tax and Excess Profits Tax, Madras

PATANJALI SASTRI C.,J.-This appeal arises out of a reference made by the Income-tax Appellate Tribunal, Madras Bench, under section 21 of the Excess Profits Tax Act, 1940 (hereinafter referred to as the Act). S.C.R. SUPREME COURT REPORTS 1059 The appellants are merchants carrying on business in 1953 yarn in Madura and are the sole selling agents for yarn r -L .,, manufactured by the Madura Mills Co., Ltd., distribnt-!~!;. 8 ~n/~;n~ ing yarn to several constituents under forward con- v. tracts in respect of which they obtained advances of The .Oom>ni•· moneys from their constituents. During the charge- sioner of Income able accounting period (13th May, 1944, to 12th April, Tax and E~"'" P·rofit«1 Tax, 1945) the appellants received from their customern sums amounting to Rs. 7,69,569 and they claimed before the Excess Profits Tax Officer that the said sum should be treated as "borrowed monev" within the meaning of Rule 2-A of the Rules in the Second Schedule to the Act and, on that footing, no excess profits tax was payable by them for the chargeable accounting period. The Excess Profits Tax Officer re­ jected the claim and assessed them to excess profits tax of Rs. 25,404, holding that, having regard to the terms of the agreement under which the amounts were receiv­ ed, they could not in law be reganled as "borrowed money" within the meaning of that Rule. Appeals to the Appellate Assistant Commissioner and the Income-tax Appellate Tribunal having failed, the appellants applied to the Tribunal for reference of the question of law arising in the case to the High Court at Madras for its determination, and the Tri­ bunal accordingly referred the following question: "Whether in the circumstances of this case, the moneys deposited by customers with the assessee firm as security deposits were "borrowed money" within the meaning of Rule 2-A of the Serond Schedule to the Excess Profits Tax Act, 1940, either throughout the chargeable accounting period ended 12th April, 1945, or during any part of that chargea hie account­ ing period ? " The reference was lieard by a Division Bench of the Court (Satyanarayana Rao and Viswanatha Sastri JJ.) and the learned judges by their judgment dated 9th June, 1950, decided the question against the appellants but granted them leave to appeal to this Court. As is well known, during the period of the war, pro­ fits arising from a trade or business were much higher Madra,s. Patanjali 80.stri 0 .. 1. 1953 than the pre-war standard of profits and the State -- wanted to catch a portion of such profits which it K. M. s.ndLask•h-deemed to be in excess of the normal or "standard" ·manier a ons . v. profits. The Act accordmgly charges a tax on the The Oominis- "excess profits" earned under war conditions and •ioner of Inconie makes provision, inter alia, for cases where, as here, Tax ai~d Exe"• there is an increase of capital used for purposes of Profit., Tax, the business in the chargeable accounting period. In Madras. such cases the standard profits are to the increased by .PatanjaU an amount calculated by applying the "statutory Sastri O.J. percentage" (varying from 8 to 12 per cent. in differ­ ent classes of cases) to the increase in capital. Thus, with the increase in the capital employed in the chargeable accounting period, there would be an increase in the standard profits and a decrease in the excess profit~. Where the increase in the capital is brought about with borrowed money, it is but fair that such money, which plays its part in earning the larger profits, of which the Sta.te claims a substantial share, should not be deducted ·in computing the average capital used for the purposes of the business. Rule 2-A of the Rules in the Second Schedule to the Act accordingly provides that in computing the average capital during the chargeable accounting period and the relative standard period "no deduction shall be made in respect of borrowed money". In the present case, the appellants having admittedly received no security deposits during the standard period, the increase in the ·average capital employed in the chargeable accounting period would be much greater than what it has been computed to be, if the security deposits received, which were all used for the appellants' business, were treated as borrowed money and part of the average capital of their busi­ ness for the chargeable accounting period, and that, as stated above, would result in a considerable reduc­ tion of the excess profits as now assessed. V\That then is the true legal character of these security deposits? The sums in question were received by the appel­ ants under three different arrangements with their S.C.R. SUPREME COUR1' REPORTS 1061 customers evidenced by the circulars issued to them. 1953 The . first o.f the.se circulars issued on 5th May, 1944, K. M.ZLak•h· was m the followmg terms : manier and SoM "You are quite aware of the fact that we are and v. . will be, so long as the existiilg contracts of bales are .The 0~"1"'"'" . h . sioner OJ nconie closed, transferrmg t e Contract Advance Deposit Ta." and Excess amounts to the credit of current yarn account for tho Profits Tax, bales supplied to you then and there. Madras. Now, what we have decided in this connection is not Patanjali to do so as stated above, but to keep such advance Sa•tri o.J. amounts under the new heading "Contracts Advance Fixed Deposit Account" and return in cash or by bank's cheque or by insured post the advance amount of the bales booked and supplied in full under certain contract number only after completion of that con- tract with the bank's commission etc. expenses that may be incurred therein on your account. The value of the bales delivered or to be delivered for each and every time should be paid in full and this system is applicable to our future booking of con­ tracts only." This was followed by another issued on 5th Decem­ ber, 1944, which runs thus : "This is to inform you that we have changed the heading of your " Contracts Advance :Fixed Deposit" account into " Security Deposit" account. As such, we have transferred the amount which is to your credit in the former to the credit of your latter account. This is with effect from 1st November, 1944. Kindly note." The arrangement was further modified by the last circular dated 14th February, 1945, which was in these terms: "Instead of calling for amounts from you towards 'Security Deposit ' due to hales for which we are entering into forward contracts with you and return­ ing the same to you from the said deposit then and there, as we are doing now, and in order to make it feasible, we have decided to demand from you a certain sum towards Security Deposit and keep the 1062 SUPREME COUR'r REPORTS [1953] 1953 same with us so long as our business connection under -- forward contracts will continue with yo11. K. M. B. Laksh· manier and 8ons In your case, we have fixed a sum of Rs ......... for v. · the said deposit, which amount we have to keep with .The Commis· us on your approval. Against the said amount, a sum •ioner of Income f R t d l't 'th · th d ,,, o s ............... s an. s creu w1 . us now m e Tax an ,;xcess . d . l'h c } b l f R d Profits Ta;i; said epos1t. ere1ore, t ie a ance o s............ ue Madras. ' by you /to you, is to be remitted/will be returned. Kindly let us have your reply immediately in this I'atanjali connection. 8astr1: Ci.J. Please note that interest of 3 per cent. per annum will be allowed as usual to the said deposit amounts until further notice." It will be seen that before the 5th May, 1944, which covers the first seven weeks of the chargeable account­ ing period, the appellants had two accounts for each constituent, namely, a " contract deposit account " and a " current yarn account ", crediting the moneys received from the customers in the former account and transferring them to the yarn account in adjustment of the price of the bales supplied "then and there", that is, as and when deliveries were made under a con­ tract either in instalments or in full. It is clear that the amounts received from the customers under this arrangement were merely advance payments of the price which were to be adjusted against the value of the bales supplied from time to time under the forward contracts and they can in no sense be regarded as bor­ rowed money. This indeed was not disputed by :Mr. Pathak. lt was also conceded by him that the circular of 5th December, 1944, which merely changed the heading of the account in which the moneys received were credited, did not alter the legal position as it then stood. Accordingly, the question arises only with reference t,o the amounts received between 5th May, 1944, aml 14th February, 1945, which covers the major part of the chargeable accounting period and those received thereafter till the end of that period. It will be convenient to deal first with the amounts received during the last part of that period, for, if we S.C.R. SUPREME COURT REPORTS 1063 accept the view of the learned judges below that those 1953 amounts were "not. borrow.ed money, then a fortiori K. M. s. Lak•h­ must amounts received durmg the second part be held manier and sons not to be borrowed money. v. The circular of the 14th February, 1945, marks a .The O~n1imis-. sioner oJ ncome clear departure from the mode of dealmg followed by Tax and Exce" the parties before the 5th May, 1944. The amount Profits Tax, deposited by a customer was no longer to have any Madras. relation to the price fixed for the goods to be delivered under a forward contract-either in instalments or Patanjali S h b 'd] Sastri O.J. otherwise. uc price was to e pa1 JY the customer in full against delivery in respect of each contract with- out any adjustment out of the deposit, which was to be held by the appellants as security for the due perform- ance of his contracts by the customer so long as his dealings with the appellants by way of forward con· tracts continued, the appellants paying interest at 3 per cent. in the meanwhile, and having, as appears from the course of dealings between the parties, the use of the money for their own business. It was only at the end of the "business connection" with the appel- lants that an adjustment was to be made towards any possible liability arising out of the customer's default. Apart from such a contingency arising, the appellants undertook to repay an equivalent amount at the termi- nation of the dealings. The transaction had thus all the essential elements of a contract of loan, and we accordingly hold that the deposits received under the final arrangement constitute borrowed money for the purpose of Rule 2-A. The learned Attorney-General laid great stress on the fact that the amounts were deposited with the object of inducing the appellants to have dealings with the customers and for the specific purpose of being held as security for the due performance by the customers of their forward contracts, and that the appellants them­ selves fixed the amount. to be deposited in each case. These features, according to him, distinguished these transactions from a real borrowing or a real lending which the expression "borrowed money" in Rule 2-A must be taken to connote. vVe are un~ble to see how 1953 the object which the customers had in view in making K. M. s. Laksh- the deposits can affect the essential cliaracter of the manier and Son• transaction. If A pays money to B who agrees to v. return not the identical eurrency in specie but an _The Oommis- equivalent sum subsequently, no bailment arises but mnrr of Income simply a loan owing by B to A. The fact that it is Tax and Excess ll. d d · " k d"CC A ' Profits Tax, ca e a " epos1t can ma e no l!1erence. s pomted Madras. out by the Judicial Committee of the Privy Council in Nawab JVfajor Sir J11ohammad Akbar Khan v. Attar Patanfali Singh (1), the two terms are not mutually exclusive. Sastri O.J. "A deposit of money is not confined to a bai!ment of specific currency to be returned in specie. As in the case of a deposit with a hanker, it does not necessarily involve the creation of a trust hut may involve only the creation of the relation of debtor and creditor, a loan under conditions". The fact that one of the conditions is that it is to be adjusted against a claim arising out of a possible default of the depositor cannot alter the character of the transaction. :N" or can the fact that the purpose for which the deposit is made is to provide a security for the due performance of a colla­ teral contract invest the deposit with a different character. It remains a loan of which t-he repayment in full is conditioned by the due fulfilment of the obli­ gations under the collateral contract. The Attorney-General placed strong reliance, as did the learned judges in the High Court, on the English decisions in Inland Revenue Commissioners v. Port of London Authority (2) and Inland Revenue Commissioners v. Rowntree & Co. Ltd. (3). In the first case it was held that the stock issued by the Port of London Authority as consideration for the acquisition of the property of certain dock companies of London, which carried in­ terest and was redeemable after twenty years, could not be regarded as representing " borrowed money " under Rule 2 of Part III of Schedule IV of the Finance (No. 2) Act, 1915, as that expression referred to "a real borro"'ing and a real lending ". The transaction was held to be a purchase of assets for consideration in the shape of the stock i:;sned, though it was attended (1) (1936) LR. 63 I.A. 279. (2) L.R. [1923) A.C. 507. H.C.R. SUPREME COURT REPORTS 1065 with incidents in some respects similar to those which 1953 would have en°sued if there had been a borrowing. It K. M.Oahh· may well be conceded that the term " borrowedmanier and Sons money" must be construed in its natural and ordinary v. meaning and implies a real borrowing and a real lend- .The Oommia- . B t th h ld" th " h th" f th aioncr of Income mg. u e o mg at t ere was no mg o e Taz and Excess kind " in the issue of stock as consideration for the P»ofits Ta.v, purchase of certain assets, where "no money passed Madras. directly or indirectly between the parties to the tran- saction " is not of much assistance in determining the Patanjali issue whether the security deposits now in question Saatri o.J. involved a real borrowing and a real lending. For the reasons already indicated, we are satisfied that they do answer to that description and constitute borrowed money within the meaning of Rule 2-A. The other case cited is still less helpful. Under certain arrangements for financial facilities, A drew 'fiills on B who accepted them and then, as an agent of A, discounted them with C and paid over the proceeds to A, who agreed to put him in funds before the matu­ rity of the bills for paying them off. The Court of Appeal held that the money thus raised was not "borrowed money" within the meaning of para­ graph 2 (1) of Part II of the Seventh Schedule to the Finance (No. 2) Act, 1939, which provided that "any borrowed money shall be deducted" (for the purpose of Excess Profits Duty). After referring to the Port of London case (supra) as authority for the view that the words " borrowed money " require the existence of a borrower and a lender and that there must be a real borrowing in the legal sense of the word, the learned judges proceeded to inquire who oould be the lender, if any, in the circumstances of the case and found there was none-not B, for an acceptor of a bill need not have any money in his hands at all to lend, not C who was only acquiring certain rights in the bill under the law merchant but was not lending money. They accordingly found it" impossible to discover that there was such a relationship" (of lender and borrower) either between A and B or between A and C. In the 138 106() SUPREME COURT REPORTS [1953} 1953 present case, the relationship of lender. and borrower -- in all its essential features is plainly recognisable bet- K. M. 8 · C,okah- th d 't d th !!' t d ti t d . mauier ond Son.• ween · e epos1 ors an , e appe an S, an Ia ect- v. sion does not affect the matter one way or the other. The Gommis· On the other hand, a more recent decision sirmer of Inconn f h E ]' h (' f A ] ' D ' Th Ta" awl 1'xcess 0 t e ng IS .. ourt 0 ppea Ill a vies V, e Profits Tm:, Shell Company of China (1), which Mr. Pathak Madras. brought to our notice, is more in . point. A British Company, which sold petroleum products in Patanjnfi China through Chinese agents, required the latter to 80 ' 1ri· o.J. deposit with the company a sum of money in Chinese dollars to be held as security against possible default by the agent in payment for the products consigned to them and to be repaid when the agency came to an end. These deposits were, during the war, transferred to the United Kingdom for reasons of safety and were there held in sterling. Subsequently, when the Chine134il dollar depreciated in relation to sterling, the amounts required to repay the deposits in Chinese dollars were much less than the sums held by the company as ster­ ling equivalents of the deposits, and the question arose whether such deposits were trading receipts or receipts of a capital nature. In holding that they were capital receipts and the profit was therefore a capital gain, Jenkins L.J., who delivered the leading judg­ ment, observed : "If the agent's deposit had in truth been a payment in advance to be applied by the company in discharg­ ing the sums from time to time due from the agent in respect of petroleum products transferred to the agent and sold by him, the case might well be difficult and might well fall within the ratio decidendi of Landes Bros. v. Simpson(') and Imperial Tobacco Co. v. Kelley.(') But that is· not the character of the de­ posits here in question. The intention manifested by the terms of the agreement is that the deposit should be retained by the company, carrying interest for the benefit of the depositor throughout the terms of the agency. It is to be available during the (1) (1951) 32 Tax Cas. 133. (~) (1934) 19 Tax Cas. 62, (3) (1943) 25 Tax Cao. 292, • • S.C.R. SUPREME COURT REPORTS 1067 deriod of the. agency for making good the agent's J9S3 p~fa~ltsin t~e event of ~ny ~efault by him; hut.other- K. M.-~~Laksh· wise 1t remams, as I see 1t, snnply as a loan owmg by 11ianie' a11J Sona the company to the agent and repayable on the termi. v. nation of the agency; and I do not see how the fact The Oommis· that the purpose for which it is given is to provide <c sioncr of l:wonie security against any possih!ll default by the agent can Tax "'."1 E~cesa . t 't 'th tl .h t f t d' . " Profits 1 ax, mves 1 -w1 ie c arac er o a ra mg receipt. Madraa, The Attorney.General relied also upon certain deci· sions holding that security deposits received from Patmijali 1 . d . h fid . h Saatri O,J, emp oyees were 1mpresse wit a umary c aracter so that the depositors were entitled to preferential payments from the assignee in bankruptcy of the depositee. He admitted, however, that there were decisions holding the other way, and we do not think it necessary to discuss that class of cases, as the man­ ner in which such sums have to he dealt with under the Insolvency Acts has no direct bearing on the question now under consideration. Turning now to the deposits received by the appel­ lants from 5th May, 1944, to 14th February, 1945, we are of opinion that, having regard to the terms of the arrangement then in force, they partake more of the nature of trading receipts than of security deposits. It will be seen that the amounts received were treated as advance payments in relation to each "contract number" and though the agreement provided for the payment of the price in full by the customer and for the deposit being returned to him on the completion of delivery under the contract, the transaction is one providing in substance and effect for the adjustment of the mutual obligations on the completion of the con­ tract. We hold accordingly that the sums received during this period cannot be regarded as borrowed money for the purposes of Rule 2.A. Lastly, Mr. Pathak suggested that the case having proceeded both before the Excess Profits Tax authori­ ties and the High Court on the footing that if the sums received from the customers during any part of the chargeable accounting period were held to be borrowed, w.;J money, they must be included in the computation of K M.~Laksh· the ave~age pr?fits for ~h~ w~ole of the chargeable manier and Sons accountmg period, no d1stmct1on should now be made v. between one part of the period and another for this _The Gommis- purpose. We cannot accept th1_1t view. It is true to "oner of Income say that no such distinction was in fact made at any Tax and Excess r b th t · b 't h Id th t Profits Tax, stage so iar, ut a is ecause 1 was e a none Madras. of the sums received under any of the arrangements was borrowed money within the meaning of Rule 2-A. Patanjali But, if it be held that the amounts received under one 8astri 0 .. 1. or more, but not all, of the agreements are borrow­ ed moneys, then, obviously, the computation of aver­ age capital in accordance with Rule 2-A must take in­ to account the different character of the sums received nuder each of the agreements which was in force during a part only of the chargeable accounting period. The form of the question referred to the court clearly recognises this and admits of a distinction being made, if necessary, between parts of the chargeable account­ ing period. In the result we set aside the order of the court below and answer the question referred in the affirmative with reference to the last part of the chargeable accounting . period, namely, 14th February, 1945, to 12th April, 1945, and in the negative with reference to the rest of that period. We make to order as to costs. Order set aside. Agent for the appellants : N aunit Lal. Agent for the respondent: G. H. Rajadhya.ksha.