Resolute as ever, Vikram went back to the tree, hoisted the corpse
over his shoulder and started walking silently. After a while Betal
said, ' Well, no point in keeping quite. To pass the time, let me
give you a few facts so that I can see you grasp on the subject.'
'Long back, five people formed a partnership of which Mrs. P was also
one, entitled for a 15% share in the profits and losses. The deed
also provided that an outgoing partner had to give three months
notice of intention in writing to sever his/her connection with the
partnership and the continuing partners had an option to purchase
his/her share at a price that was to be calculated in the manner
provided in the deed. There was a provision in the deed for
settlement of disputes amongst the partners by arbitration.
The business prospered and went along for a long time. After a
period of time serious disputes arose between the partners and
reached a stage where Mrs.P decided to quit. However the partners
realised that even though the profitability was excellent and the
net worth of the firm was very healthy, a substantially huge portion
of the capital of the partners was locked up in land, building, plant
and machinery. Mrs. P's account could be settled only by selling
these assets but that would effectively result in the closure of the
business. No partner was in a position to bring in fresh capital to
pay off her account either. The elders and well-wishers gathered and
an agreement was arrived at. According to that Mrs. P agreed to leave
her capital in the firm and in return the continuing partners agreed
to pay her 15% of the profits for the year or 12% per annum interest
on the capital left by her whichever amount was higher. This
agreement would subsist till the entire capital of Mrs. P was paid
off.
The continuing partners carried on and paid 15% of the profits of
each year to Mrs. P. The firm wrote off the amount paid to Mrs. P as
royalty on capital and claimed it as an expenditure. In the
assessment, the Assessing Officer disallowed it holding that it was a
sham transaction. He held that in reality Mrs. P never retired from
the partnership and is actually receiving a share in profits. He
ruled that the 15% of the profits paid over to her was only an
application of its income and had no connection with earning the
income. Hence it was not a deductible expenditure. The assessee's
appeal was dismissed by the CIT(A) but allowed by the ITAT. The
department then approached the High Court with a reference u/s256.'
'Well,' continued Betal, 'I don't know what happened afterwards. I
was wondering how you would have decided if the case had come before
you. And you know of course, that your head will burst into a million
pieces if you dont answer me despite knowing'.
Vikram replied:
' Here we have to first of all decide whether a valid partnership
exists. Next we have to see whether the amount paid over to Mrs. P is
an application of earned income or a diversion of the same even
before it reached the hands of the firm. It is to be noted also that
the department has not questioned the importance of the capital left
in the firm by Mrs.P'.
A partnership is said to exist between two or more persons when there
is an agreement to share profits and losses of a business carried on
by them. In the instant case, Mrs. P is entitled for 15% share of
profits or 12% interest on capital, whichever is higher. In other
words, she is entitled to receive something whether or not the firm
makes a profit and she is in any case not liable for the losses after
the date of her retirement. Therefore the Department fails in its
first contention.
Regarding the diversion at source, the true test is whether the
amount sought to be deducted, in truth, never reached the assessee
firm as its income. Obligations, no doubt, there are in every case,
but it is the nature of the obligation, which is the decisive fact.
There is a difference between an amount, which a person is obliged to
apply out of his income and an amount, which by the nature of the
obligation cannot be said to be a part of the income of the assessee.
Where, by the obligation, income is diverted before it reaches the
assessee, it is deductible; but where the income is required to be
applied to discharge an obligation after such income reaches the
assessee, the same is called an application of income. It is the
first kind of payment that is allowed as a deductible expenditure but
not the second. The second payment is merely an obligation to pay
another a portion of one's own income, which has been received and is
since applied.
In the instant case, the reconstituted firm could arrive at its true
profits or losses only after providing for the amount that was due to
Mrs. P. The reference to 15% profits by itself is immaterial since it
is only one of the methods of arriving at the amount due to her.
Therefore the amount computed as payable to her is a clear case of
diversion of income at source by an over riding title. The amount
accrues to Mrs. P before the firms becomes entitled for the profits
for the year. Finally, as the department has never contested the
value or worth of the capital left by Mrs. P, one can safely conclude
that it was a necessity for the firm to continue its business. Hence
it constitutes a genuine borrowing.
Based on the above, I would hold that the amount paid to Mrs. P is a
deductible expenditure in the hands of the firm.'
'Great!', said Betal, 'I know you that you would come with the right
answer. But what to do? You also know that I'll vanish the moment you
give me the answer'.
With that Betal vanished.
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