JUDGMENT
Ajtt Kumar Sengupta, J.
1. At the instance of the Commissioner, the following two questions have been referred to this court under Section 256(1) of the I.T. Act, 1961.
“1. Whether, on the facts and in the circumstances of the case, remuneration paid to the manager could be allowed under Section 37(1) of the Income-tax Act, 1961, for all the assessment years 1967-68, 1968-69 and 1969-70 ?
2. Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the payment of the entire interest for the first year under appeal was deductible revenue expenditure and also in reducing the payment of interest by Rs. 12,000 for each of the assessment years 1968-69 and 1969-70 ?”
2.
The facts pertaining to the first question are briefly stated as under:
The assessee paid a salary of Rs. 2,000 per month to its manager. The assessee claimed deduction of Rs. 24,000 being the salary paid to the manager for each of the assessment years 1967-68, 1968-69 and 1969-70. The ITO allowed the claim to the extent of Rs. 10,000, following his order for the assessment year 1966-67 and disallowed Rs. 14,000 for each of the said assessment years. All the three assessments were completed on 28th February, 1972. On appeal, the AAC, after taking into account the cumulative effect of all evidence and facts and circumstances, held that the payment of Rs. 18,000 per annum was reasonable and sustained the disallowance to the extent of Rs. 6,000 for each of the said assessment years. The assessee appealed before the Tribunal. The Revenue relied upon the order of the AAC and pointed out that when the manager was the son of a director and brother of another director of the assessee-company, remuneration was not paid wholly for commercial reason. According to the Tribunal, there was no material to hold that the services rendered by the manager was not worth Rs. 24,000 to the assessee. It considered the volume of sales, total salary bill, the nature of the services rendered by the manager of a concern of the nature of the assessee and held that the remuneration paid to the manager was not excessive or unreasonable.
3. Mr. H.M. Dhar, the learned counsel appearing for the Commissioner, has submitted that the manager whose salary was disallowed partly by the ITO is a relative of a director and in view of the provisions of Section 40(c), he was justified in doing so. According to him, the Tribunal fell in error in allowing the salary of the manager in entirety. The contention of the Revenue is to be considered in the light of the provisions of Section 40(c) of the Act. Although the first question referred to us relates to the allowance of the remuneration under Section 37(1) of the Act, the income-tax authorities and the Tribunal proceeded to consider the allowance under Section 40(c) of the Act. In the statement of the case also, the Tribunal referred to the provisions of Section 40(c). In the reference application under Section 256(1), a specific question was raised by the Commissioner regarding the allowability of the remuneration of the manager under Section 40(c) of the Act. However, the Tribunal referred the question as set out earlier. Having regard to the facts and circumstances of the case and to bring out the real controversy in issue, we reframe the first question as under :
Whether, on the facts and in the circumstances of the case, the Tribunal was correct in holding that the manager’s remuneration was allowable for all the assessment years 1967-68, 1968-69 and 1969-70 ?
4. The provisions of Section 40(c) have an overriding effect over those of Sections 30 to 39. Even if the requirements of Section 37 of the Act are satisfied, the ITO is
enjoined not to make any allowance in respect of any expenditure which may come within the mischief of the provision of Section 40(c). Even if the expenditure is wholly and exclusively laid out for the purpose of business of the assessee, such expenditure will be disallowed if it comes within the mischief of Section 40(c). Under Section 40(c), the ITO has to disallow deduction in respect of excessive remuneration or benefit or amenity to a director or to person who has a substantial interest in the company or to a relative of such director or of such person. If, in the opinion of the ITO, any such expenditure or allowance is excessive or unreasonable having regard to the legitimate business needs of the company and the benefit derived by or accruing to the company therefrom, such excessive expenditure shall not be allowed in computing the income of the company. The object of Section 40(c) is to have a check in respect of expenditure which relates directly or indirectly in the provision of any remuneration, benefit or amenity to privileged persons.
5. It is not open to the ITO to mechanically follow an earlier assessment order without applying a fresh judicial mind to the facts and circumstances of the relevant year. In this case, the ITO merely followed his earlier order and he did not give any reason for disallowance. It is for the ITO to consider the entire position objectively and to find out whether any part of the remuneration paid to the manager, who happens to be a relative of a director, is justified on the facts and in the circumstances of the case. The reasonableness or excessiveness of the salary paid to the manager cannot be judged subjectively. The AAC took into consideration the fact that the manager was appointed for the first time in 1958 on a salary of Rs. 500 per month when the turnover of the company was Rs. 4,11,489. Gradually by dint of his labour and efficient administration, the turnover of the company has since been increased in the year 1962 to Rs. 8,79,975 and in consideration of his valuable service in that year, his salary was increased to Rs. 1,000 per month. In 1963, although the turnover increased to more than Rs. 13,00,000, there was no increase in the salary. In 1964, when the turnover increased to more than Rs. 18,00,000, his salary was increased to Rs. 1,500 per month and on and from the subsequent year 1965 corresponding to the assessment year 1966-67 the turnover further increased to 18,80,000 and his salary was increased to Rs. 2,000 per month. This salary of Rs. 2,000 continued from that year 1965 till 1972. Although the turnover increased year by year which was Rs. 19,00,000 in 1967, about Rs. 22,00,000 in 1968, more than Rs. 24,00,000 in 1967 and about Rs. 25,00,000 in 1970, save and except in 1966 when the turnover decreased to Rs. 11,26,612 due to limitation of import, the salary of the manager remained the same at Rs. 2,000 per month during all these years from March, 1965. The manager has been
rendering wholetime service and apart from the salary, unlike the other employees, he was not paid any commission on sales. In consideration of the cumulative effect of all the evidence and facts and circumstances, the AAC allowed the salary at the rate of Rs. 1,500 per month as against the payment of Rs. 2,000 per month. The fact and circumstances as found by the AAC were not disputed before the Tribunal. The only contention raised before the Tribunal was that the manager was the son of a director and a brother of. another director and as such the remuneration was not paid wholly for commercial reasons. The Tribunal also found that there was no evidence to hold that the manager was paid his remuneration for consideration other than commercial. Merely because he was a relative within the meaning of Section 40(c) of the Act did not entitle the Revenue authority to disallow a part of the remuneration without showing that the services rendered by him were not worthy of salary of the assessee. Considering the amount of the salary, the total salary bill, nature of services rendered by the manager of the concern and the nature of the activity carried on by the assessee and all the aforesaid facts and circumstances of the case, the Tribunal held that the remuneration paid to the manager was not in any way excessive or unreasonable. It cannot be said that the Tribunal in coming to its conclusion did not consider the relevant circumstances. The ITO did not consider any of the facts objectively and from the view-point of a prudent businessman. He has acted in a routine manner without applying his mind to the facts of the case. He has merely followed his earlier order without considering the facts of the case. Even if the earlier order has some bearing or relevance, it is the duty of the ITO to come to his finding on the materials which are available for the assessment years in question. On the facts of this case, it must be held that the assessee has established by evidence that the allowance in question is justifiable and it is neither excessive nor unreasonable having regard to the legitimate business needs of the assessee and the benefit resulting to the company. The overall circumstances established a link between the remuneration and the benefit resulting to the company. The question whether any amount claimed as expenditure or allowance is excessive or unreasonable having regard to the legitimate business needs of the assessee and the benefit derived by or accruing to it therefrom has to be decided on the facts and in the light of the circumstances of each case. The Tribunal has given reason for its finding. In our view, the Tribunal carne to a correct conclusion on the facts of this case. We, therefore, answer the first question in the affirmative and in favour of the assessee.
6. The other issue covered by the second question pertained to the allowance of interest as revenue expenditure. In the proceeding for the assessment to tax for the said assessment years, the ITO disallowed Rs. 10,545
for the assessment year 1967-68, Rs. 23,624 for the assessment year 1968-69 and Rs. 39,723 for the assessment year 1969-70 with regard to the payment of interest. The ITO found that the assessee took secured and unsecured loans during the three years on which interest of Rs. 1,24,648 in 1967-68, Rs. 1,70,852 in 1968-69 and Rs. 1,76,411 in 1969-70 were paid. The ITO found that the assessee spent certain amounts at the end of the three years under reference for the construction of house properties. He held that the construction of house properties was not the business carried on by the assessee and so the interest on borrowed capital for the construction of the house property was not an admissible expenditure in computing the business income of the assessee. He calculated proportionate interest at 12% per year on the funds invested in the construction of house properties and disallowed the amount already mentioned. On appeal, the AAC found that the interest on funds used for acquiring capital asset was admissible only when the asset in question was a business asset and that as the house property constructed by the assessee-company was meant for being let out on hire, it was not a business asset. Hence he upheld the disallowance. On further appeal to the Tribunal, the Tribunal deleted the addition for the assessment year 1967-68 while for the assessment years 1968-69 and 1969-70, it reduced the disallowance by Rs. 12,000. The Tribunal was of the view that it should be presumed that paid up capital of rupees one lakh was first spent for construction of the house and the excess over the said amount, if any, alone was spent from borrowed funds. As this amount is less than Rs. 12,000, up to which no disallowance is called for, we delete this addition. In the second year as well as in the third year, we reduce the disallowance by Rs. 12,000.
7. The contention of Mr. Dhar, learned counsel for the Revenue, is that in this case, the capital was not borrowed for the purpose of business as the assessee company had invested a part of the borrowal for construction of a house property. It was further contended that in any event the Tribunal was not right in restricting the disallowance to Rs. 12,000 for two years on the ground that out of the total investment for the construction of the house property, rupees one lakh was invested out of the paid up capital. It is contended that there is no material for such conclusion.
8. The ITO found that the assessee obtained the loan for the purpose of the business. Since a substantial portion of the said loan had been utilised by the assessee for the purpose of construction of house property, the ITO disallowed proportionate interest on the investment made on such construction. The AAC upheld the finding of the ITO on the ground that part of the borrowed capital was not utilised for the purpose of carrying on the business and the house property which was constructed was not
a factory building but merely an investment and the assessee company by letting out the house property derived rental income assessable as income from house property under Section 23. Under Section 36(1)(iii) of the Act, interest on capital borrowed for the purpose of business is allowable as business expenditure. The test is whether the capital has been borrowed for the purpose of the business. It has been found by the authorities that the assessee obtained the loan for the purpose of the business. Where the borrowed moneys are not used for the purpose of the business but are utilised for meeting the personal obligation of the assessee, the claim for interest would not be allowable. It cannot be laid down as a general rule that where an assessee utilises a part of the borrowing to make an investment on business considerations and if the income from such investment is not assessable as business income, the assessee will not be entitled to the deduction of interest on such investment made out of the capital borrowed for the purpose of the business. Unless the borrowing is not completely unrelated to the purpose of the business, the interest paid on such borrowing cannot be disallowed. The assessee contended before the AAC that from the details of the secured and unsecured loans, it would appear that the company took the loans for its day to day carrying on of its business and no amount is earmarked or taken for the construction of the building. Whatever amount was spent for construction, it came out of the company’s business receipts. But the contention of the assessee before the Tribunal was that the funds used for the construction of the house should be deemed to have come from the paid up capital of the company instead of from the borrowed funds and so to that extent, the disallowance should be reduced. The Tribunal accepted the said contention of the assessee on the following reasons :
“We agree with the revenue authorities that interest on funds borrowed and not used for the purpose of the assessee’s business is not admissible because of the provisions of Section 36(1)(iii) which reads: ‘the amount of the interest paid in respect of capital borrowed for the purpose of the business or profession’. However, we find much force in the alternative contention of Shri Chattopadhyay. The paid up capital of the assessee as at the beginning of all the three years under consideration was rupees one lakh. It is, in our opinion, quite reasonable to hold that this sum of rupees one lakh was first spent for the construction of the house and the excess over the said amount, if any, alone was spent from borrowed funds. The interest on this amount at 12% as taken by the ITO comes to Rs. 12,000. We find that the capital on which interest at 12% was disallowed by the ITO was more than rupees one lakh in each of the three years under consideration. In the first year, the ITO has disallowed Rs. 10,545. As this amount is less than Rs. 12,000, up to which no
disallowance is called for, we delete this addition. In the second year as well as in the third year we reduce the disallowance by Rs. 12,000.”
9. There is no evidence before the Tribunal to hold that the paid up capital of the assessee company was first spent for construction of the house property and the excess over the said amount, if any, incurred in the said construction alone was spent out of the borrowed funds. On the contrary, it was found by the ITO that the assessee invested Rs. 1,25,892, Rs. 71,353 and Rs. 46,970 on the house property for the assessment years 1967-68, 1968-99 and 1969-70 respectively. The assessee could not specify the funds which had been utilised for the purpose of construction and as such the ITO held that a part of the assessee’s borrowings have been utilised for the construction of the house property. The Tribunal had no material to link the paid up capital with the investment made in the house property. The Tribunal was also not correct in holding that the assessee was having paid up capital to the tune of rupees one lakh for the three years in question. If the paid up capital was invested in the first year, then there was no further paid up capital for being invested in the subsequent years. There was no material before the Tribunal for coming to its conclusion or drawing any presumption. The Tribunal should not have proceeded on assumption of facts. The entire approach of the Tribunal is erroneous. The findings of the ITO confirmed by the AAC were not challenged by the assessee before the Tribunal. The assessee was maintaining a mixed account. The Tribunal should have considered whether the business receipts or other funds, if at all available with the company, were sufficient to meet the investments made in the construction of the house. Nor did the Tribunal find out to what extent the borrowed capital was invested in the construction of the house. The Tribunal cannot proceed on the presumption that investments in the house property were made out of the paid up capital and not out of the capital borrowed for the purpose of the business. The Tribunal without finding out whether investment in the construction was made out of the profits of the relevant year or out of other funds available with the assessee or out of the borrowed capital, should not have proceeded on the assumption that such investment was not made out of the monies borrowed for the running of the business but out of the paid up capital. Since the Tribunal has not brought on record the facts necessary for determining the question referred to us, we are unable to answer the question. We, therefore, decline to answer the second question. The Tribunal will dispose of the matter in the light of the observation made in the judgment.
10. There will be no order as to costs.
Dipak Kumar Sen, J.
11. I agree.
