JUDGMENT
1. This is an IT reference under Section 256(1) of the IT Act in which the following question has been referred to us for our opinion :
"Whether, on the facts and circumstances of the case, the Tribunal was legally justified to disallow Rs. 19,000 out of remuneration payable to Abdul Qayum Ansari and Abdul Quddus Ansari ?"
2. We have heard learned counsel for the parties.
3. The assessee is a company registered under Indian Companies Act which is engaged in manufacture and export of carpets. The relevant assessment year is 1978-79. The dispute in this case is about the increase of salary of two of the directors, Sri Abdul Qayum Ansari and Abdul Quddus Ansari, who were earlier paid salary of Rs. 1,595 per month each, but this salary was increased to Rs. 2,987 per month each w.e.f. 1st Jan., 1976. This increase in the salary of the two directors of the assessee-company was disallowed, in respect of which this present reference has been made. The IAC disallowed the claim of the assessee in respect of this increase of the salary of the directors. The CIT(A), however, reversed the order of the ITO and allowed the claim of the assessee. The Tribunal allowed the assessee's claim in part. The Tribunal disallowed Rs. 19,000 out of the remuneration instead of the disallowance of Rs. 23,688 by the IAC.
4. Learned counsel for the assessee, Sri Vikram Gulati has relied on the decision of the Calcutta High Court in CIT v. Edward Keventer (P) Ltd. (1972) 86 ITR 370 (Cal) which has been upheld by the Supreme Court in CIT v. Edward Keventer (P) Ltd. (1978) 115 ITR 149 (SC) and Pioneer Spring & Steel Concern (P) Ltd. v. CIT, (1982) 135 ITR 522 (Cal) and Extrusion Process (P) Ltd. v. CIT, (1979) 119 ITR 287 (Bom). The aforesaid decisions were given in connection with Section 10(4A) of the 1922 Act, but in our opinion their ratio is also applicable to Section 40(c)(i) of the 1961 Act (before its deletion w.e.f. 1st April, 1989) r/w Section 40A(2).
5. Under Section 40(c)(i), the AO could disallow any payment to a director which in his opinion is "excessive or unreasonable having regard to the legitimate business needs of the company and the benefit derived by or accruing to it therefrom". A similar provision exists in Section 40A(2) of the 1961 Act.
6. The point which needs to be considered is who is to decide the legitimate business needs of the company, the company itself or the ITO ? The Calcutta High Court has observed in the aforesaid decision that "The legitimate business needs of the company must be judged from the viewpoint of the company itself, and must be viewed from the point of view of the prudent businessman. It is not for the ITO to dictate what the business needs of the company should be." The Calcutta High Court referred to the decision of the Madras High Court which, in Natesan & Co. (P) Ltd v. CIT (1964) 51 ITR 386 (Mad) observed : "The Department was forbidden to sit in the armchair of the management of the company and decide what would be the proper remuneration." We respectfully agree with the view taken by the Calcutta and Madras High Courts.
7. In Newtone Studios Ltd. v. CIT (1955) 28 ITR 378 (Mad), it was observed that the remuneration paid to a director should not be rejected by the AO on any subjective standard of reasonableness, and that so long as the reality of the payment was not challenged and no allegation was made that the payment was dictated by other than business considerations, the deductibility of the expenditure should be considered from the point of view of the businessman and not from the point of view of any outsider, including the AO. A disallowance can be made on the ground that the payment is not for commercial expediency, but not on the ground that in the opinion of the AO it is unreasonable high.
The test in every case is that of any prudent businessmen.
8. We respectfully agree with the aforesaid view.
9. In our opinion whenever a claim is made by the assessee before the ITO for allowing an expenditure as a legitimate business expenditure, the approach of the ITO (or other IT authority) has to be that he has to look at the matter from the viewpoint of a prudent businessman, and not from his own viewpoint, and then ascertain whether the said expenditure has been incurred for the purpose of commercial expediency or not. In other words, the ITO must try to put himself in the shoes of a prudent businessman and try to look at the matter from that point of view.
10. A businessman may make an expenditure, which he is under no legal obligation to make, but if he does so as a measure of commercial expediency, it must be allowed under Section 37 of the IT Act as a legitimate business expenditure. For instance, if a businessman makes a payment to the workers over and above the amount of bonus, which he is legally under obligation to pay under the Payment of Bonus Act, the said expenditure has yet to be allowed as a legitimate business expenditure if it has been incurred to maintain industrial peace, vide CIT v. Arcuttipore Tea Co. Ltd. (1992) 197 ITR 588 (Cal). Similarly, a payment made by a company for settling its dispute with another arising out of a business deal is allowable, even if it is ex gratia, since it is for commercial expediency, vide Sassoon J. David & Co. (P) Ltd. v. CIT (1975) 98 ITR 50 (Bom). Compensation to workmen for premature retirement is for commercial expediency, vide CIT v. Machinery Mfg. Co., (1992) 198 ITR 559 (Cal). It often happens that a businessman makes certain expenditures not under any legal obligation, but for smooth functioning of his business and to facilitate his business. These have to be treated as legitimate business expenditure.
11. In Atherton v. British Insulated & Helsby Cables Ltd. (1925) 10 Tax Cases 155 (HL) the House of Lords held that in order to claim a business deduction it is enough to show that the money is expended not of necessity but voluntarily and on grounds of commercial expediency, and in order indirectly to facilitate the carrying on of the business. This enunciation of the law in the above decision has become classic. Due emphasis, it was pointed out by the House of Lords in Morgan (Inspector of Taxes) v. Tate & Lyle Ltd. (1954) 26 ITR 195 (HL) should be accorded to the word 'indirectly' in this enunciation. This view has been followed by our Supreme Court in Eastern Investment Ltd. v. CIT (1951) 20 ITR 1 (SC) and in CIT v. Chandulal Keshavlal & Co. (1960) 38 ITR 601 (SC).
12. Similarly, when a company pays a higher salary to the directors or the managers or other officers or employees as a matter of commercial expediency, it is not for the ITO to say that in his opinion the said salary should not have been paid. A company may decide to pay a higher remuneration to its directors, officers or employees so as to encourage them to work hard, expand the business, or for a host of other commercial considerations and the matter has to be looked at from the viewpoint of the company.
13. In the present case the assessee has contended that it has increased the salary of the directors because the sales had gone up as mentioned in para. 8 of the order of the CIT(A). The CIT(A) has considered the matter in great detail and has noticed the increase in the sales in the relevant assessment year and has observed that such good performance was the result of very good and serious work by the directors. In the order of the Tribunal no good reason has been given why the claim of the assessee has been partly disallowed. In our opinion, there was no good ground for making such disallowance. It seems that the Tribunal lost sight of the correct legal principles (mentioned above) for determining whether to allow the expenditure or not. We reiterate that it is not for the IT authorities to determine what would be commercially expedient, and that is the function of the company or the firm. The IT authorities cannot ordinarily interfere in such matters.
14. It is not for the ITO to decide what would be the correct salary of the directors or other officers of the company, unless on the face of it the salary fixed is so exorbitant and absurd, that it can clearly be said to be fictitious and aimed at tax evasion.
15. For the reasons given above, we answer the question referred in the negative, i.e. in favour of the assessee and against the Department and restore the order of the CIT(A). Before parting with this case we would like to add that in the present environment when the Indian economy has been opened up and large salaries are being given to bright and highly qualified young recruits in business firms (sometimes as much as Rs. 50,000 to Rs. 1,00,000 per month as starting salary), it is not for the IT authorities to say that such salaries are excessive or unreasonable. It is only if there is something absolutely fantastic or absurd that the IT authorities can intervene in such matters. If we do not take such a view, then the best young talent in India, e.g. the best graduates from IIT/IIM, etc. will leave the country and not stay in India and contribute to its progress. Hence, we are of the opinion that the time has come when the approach of the authorities should change in the light of the new developments in the world so that the best talent may remain in India and not become part of the 'brain drain'.