JUDGMENT This is reference by the Income-tax Commissioner under Section 66 (2) of the Income Act (XI of 1922) and the main question that arises for consideration relates to the allowance to be made on account of depreciation of certain buildings, machinery etc., in computing the taxable profits of a certain "Business". The answer to this question depends on the true interpretation of Section 10(2) (vi) and Section 26(2) of the Act. Section 10 (2) (vi) provides that in computing profits or gains of any business for the purposes of income-tax allowance shall be made "in respect of depreciation of such buildings, machinery, plant, or furniture being the property of the assessee, a sum equivalent to such percentage on the original cost thereof to the assessee as may in any case or class of cases be prescribed." Section 26 (2) enacts that "where at the time of making an assessment under Section 23, it is found that the person carrying on any business, profession or vocation has been succeeded in such capacity by another person, the assessment shall be made on such person succeeding, as if he had been carrying on the business, profession or vocation throughout the previous year, and as if he had received the whole of the profits for that year."
The reference arises under the following circumstances :-
An order for the winding-up of the Union Indian Sugar Mills Company Limited, Cawnpore, (hereinafter referred to as the Mills), which carried on an extensive business, was made on a creditors petition on May 28, 1926. Within a few months of this order, viz., on the 15th of September, 1926, certain persons including one L. Kamlapat entered into a partnership with a view to take over and run the Mills which had gone into liquidation. This partnership was styled as the firm of Kamlapat Moti Lal (hereinafter referred to as the assessee).
On the 22nd of November 1926, the assessee filed an application in this court embodying alternative proposals to take a mortgage of the Mills or to purchase the same. The proposals embodied in the petition were as follows :-
"That the applicant is willing to advance a sum of Rs. 10 lakhs to the above Company in liquidation on the terms annexed herewith and is also prepared to purchase it for rupees eleven lakhs fifty thousand on the conditions mentioned therein.
"1. Deposit of Rs. 1,50,000 today and Rs. 8,50,000 within a month of this date, which should be paid to creditors as early as possible, the balance, if any, after paying the legal debts to be returned to us.
"2. The company to be mortgaged to us at 9 per cent compound interest with 6 monthly rests.
"3. We to be the managing agents for ten years even if mortgage paid off earlier, and to get all the advantages which the present managing director enjoys and to get 5 per cent commission on net profits only.
"4. The mortgage with interest to be paid off first and then the shareholders to get the profit.
"5. We to provide entire working capital against the goods of the Company at 8 percent per annum.
"6. The Company to be handed over to us as soon as we deposit the entire money.
"7. The consent of the shareholders to be obtained to the above scheme.
"8. In case the shareholders do not accept the scheme, we are willing to purchase the Company at Rs. 11,50,000.
(Sd.) KAMLAPAT.
(Sd.) RAMAKANT MALAVIYA Vakil for L. Kamlapat.
These proposals were in due course put for consideration before a meeting of the shareholders of the Mills on December 16, 1926, and the meeting decided in favour of the Mills being mortgaged to the assessee. This Court, accordingly, sanctioned the mortgage on the terms embodied in the petition quoted above.
On December 21, 1926, the liquidators reported that the amount due to the creditors was about Rs. 10,62,000 and the sum of Rs. 10 lakhs that the assessee agreed to advance on mortgage was insufficient to satisfy the claims of all the creditors. It appears to have been suggested that the assessee might be prepared to take the mortgage for Rs. 10,62,000 and this Court then adjourned the matter to enable the assessee to increase the offer of Rs. 10 lakhs for the mortgage of the Mills, but directed that possession of the Mills be immediately handed over to the assessee on the understanding that the out-and-out sale of the mortgage should be effected in favour of the assessee in the near future.
The assessee paid Rs. 10 lakhs to the liquidators and possession of the Mills was handed over to the assessee on December 28, 1926. The assessee then began to run the Mills in the old name of the "Union Sugar Mills Company Limited."
On January 7, 1927, the assessee agreed to increase its offer by a sum of Rs. 62,000 and this Court then on February 25, 1927, approved the proposed scheme for the mortgage of the Mills for Rs. 10,62,000 and directed that a mortgage-deed be executed in favour of the assessee and then the assessee paid the additional amount of Rs. 62,000 to the official liquidators. Disputes however arose between the liquidators and the assessee as to the terms of the mortgage-deed with the result that litigation ensued between them which culminated in an appeal to His Majesty in Council. The appeal was decided by their Lordships of the Privy Council on July 5, 1929, and their Lordships decision is reported as Kamlapat Moti Lal v. Union Indian Sugar Mills Company, Limited, (1929 A.L.J., p. 1289). Their Lordships held that as the shareholders of the Mills had "not assented to the scheme as approved, the orders of the Court, dated February 25, and certain subsequent orders of the Court, dated February 25, and certain subsequent orders must be set aside". Their Lordships further directed that "a meeting of shareholders should be summoned to consider the amended scheme; and it seems advisable that the scheme as laid before the shareholders should be more detailed than before; and should reserve the power of the Court to approve modification. Meanwhile proceedings in the liquidation should be confined to the steps necessary for laying the scheme before the meeting and reporting thereon to the Court".
In the course of their judgment their Lordships observed that "they have no doubt that the proposed mortgage is an usufructuary mortgage; and that no further duty of care can be imposed upon the mortgagees than arises out of the statutory duties imposed upon mortgagees in possession under Section 76 of the Transfer of Property Act on the one hand, or of the ordinary legal duties of managing agents on the other".
After the decision of their Lordships the matter was again considered by a meeting of the shareholders of the Mills and the meeting approved the scheme to mortgage the Mill for Rs. 10,62,000. The assessee had however, in the meantime withdrawn the offer to take a mortgage of or to purchase the Mills and this Court then directed the liquidators to file a suit against the assessee for specific performance of contract. The liquidators accordingly filed a suit against the assessee for specific performance, but that suit was dismissed by the Subordinate Judge of Cawnpore on the 6th of January 1931. No appeal was taken against that decision and the decision became final.
It would appear from the facts set out above that a very anomalous position arose by the year 1931. The assessee had paid a sum of Rs. 10,62,000 and had worked the Mills all through though no deed transferring the Mills to the assessee either as mortgagee or as vendee was ever executed. From the year 1926 to 1931 the assessee was running the mills in the capacity of managing agent, and during this period the Mills were all along working at a loss, and this accounts for the anxiety on the part of the assessee on the one hand to back out from the proposals submitted to this Court in the year 1926 and on the other for the insistence of the official liquidators to hold the assessee to its bargain. Fresh negotiations were started with the result that the liquidators sold the Mills to the assessee on the 18th of May 1932, for a sum of Rs. 11,12,000. The assessee had already paid Rs. 10,62,000 and paid the balance of Rs. 50,000 and the ownership of the Mills passed to the assessee in May 1932.
As there was no profit till the end of 1931 no income-tax was assessed and no allowance on account of depreciation on buildings, machinery etc. was allowed. It is common ground that by the year 1932 the Mills were entitled to an allowance of Rs. 5,62,151 on account of depreciation in accordance with the provisions of Section 10(2) (vi) of the Act.
For the first time in the year 1932 there was a profit of Rs. 1,34,318 in the business and the assessee was, subject to allowance on account of depreciation, liable to pay income-tax on this amount with respect to the assessment year 1933-34. In the return submitted by it the assessee, while showing the above amount as profit, claimed Rs. 5,62,151 as allowance on account of unabsorbed or accumulated depreciation from 1926 to 1932. The assessee further maintained that it had spent a sum of about Rs. 27,000 in making additions to the buildings and machinery during the above period and that this amount should also be taken into account in calculating the depreciation. In short the assessee maintained that it was not liable to pay any tax on account of the year 1933-34. The claim for allowance on account of depreciation was based on the provisions of Section 26 (2) read with Section 10 (2) (vi) of the Act.
The Income-tax Officer held that the assessee could not "be treated as the successors" to the business carried on by the Mills within the meaning of Section 26 (2) of the Act, and, as such, was not entitled to any allowance on account of the unabsorbed depreciation up to May 1932, when the ownership of the Mills passed to the assessee. He also disallowed the claim for depreciation with respect to the amount alleged to have been spent by the assessee previous to 1932 in making additions to the buildings and machinery. He however, allowed depreciation calculated "on the original cost", viz., on Rs. 11,12,000 - the price paid by the assessee for purchasing the Mills and made assessment accordingly.
The assessee appealed to the Assistant Commissioner of Income-tax who held that the assessee had "purchased the Mills as a going concern" and that, therefore, the assessee was "to be treated as having succeeded to the business within the meaning of Section 26 (2) of the Income-tax Act". He, however, overruled the contentions of the assessee as regards the unabsorbed depreciation and as regards the cost of additions made in the buildings and machinery and held that the assessee was entitled to depreciation "calculated on the cost to the assessee", viz., on Rs. 11,12,000. In support of this conclusion he relied on the decision of their Lordships of the Privy Council in Commissioner of Income-tax, Madras v. The Buckingham and Carnatic Company Ltd. (I.L.R. 59 Madras, p. 175). Having arrived at these conclusions he proceeded to spilt the profits of 1932 into two periods, viz., for the period prior to the sale of the Mills to the assessee and for the period subsequent thereto.
(1) The profits for the former period amounted to ... Rs.
39,338 (2) The profits for the second period amounted to ... Rs.
94,980 Total ... Rs.
1,34,318 He treated the sum of Rs. 39,338 as the income of the Mills and held that as the Mills were "entitled to depreciation of Rs. 5,62,151 brought over from the previous year the whole of this profit will be set off against the depreciation allowance... and no income will be taken into account." He held that the depreciation for the period subsequent to the purchase of the Mills by the assessee will be allowed "on the cost" at which the assessee had purchased the Mills. In this connection he overruled the contention of the assessee that in calculating the cost price of the Mills to the assessee a number of liabilities to which the Mills were subject should be taken into account and that the cost price of the Mills to the assessee should be deemed to be Rs. 21,35,375 and not only Rs. 11,12,000. In the result he made assessment on Rs. 94,980. It would be noted that in making this assessment the Assistant Commissioner did not make allowance on account of depreciation even on the costs price to the assessee.
The assessee then filed an application to the Commissioner of Income-tax praying that either the order of the Assistant Commissioner be reviewed under Section 33 or the case be stated to the High Court in accordance with Section 66 (2) of the Act. The Commissioner rejected the application for review but made the present reference to this Court. The questions referred are :-
"(1) In the circumstances stated, having regard to the fact that the sale deed (Appendix A) was executed on 18th May, 1932, was the assessee entitled to depreciation on the machinery and buildings in question with effect from 28th December 1926, the date on which in pursuance of the mortgage scheme sanctioned by the High Court it (the assessee) was put in possession of the Mills ?
(2) On a correct interpretation of the sale deed (Appendix A) referred to above was the assessee entitled to include as the original cost of the machinery and buildings (1) the losses incurred by it in working the Mills (2) the interest on the sums advanced to the liquidators and (3) the interest on the capital invested by it during its incumbency as mortgagee and managing agent of the Union Indian Sugar Mills Company, Limited, Cawnpore ?
(3) In the circumstances stated, was the assessee entitled to depreciation on the amount of (1) Rs. 13,391 and (2) Rs. 14,035 representing respectively the original cost of additions to buildings and machinery made by it during such incumbency ?"
The answer to the first question must, in our judgment be in favour of the assessee. It is conceded by the learned Advocate. General, who appeared on behalf of the Income-tax Department that the assessee succeeded to the business of the Mills in May 1932 and that accordingly the assessment is to be made in accordance with the provisions of Section 26(2) of the Act. In short the parties are agreed that the assessment is to be made on the assumption that the assessee had been carrying on the business throughout the whole of the "previous year", viz., the year 1932, and had received the whole of the profit for that year. But the parties are at variance as to the principle on which allowance for depreciation is to be made.
It is contended on behalf of the assessee that in the computation of the profits for the year 1932 all the deductions to which the Mills would have been entitled in accordance with Section 10 (2) if there was no sale in favour of the assessee, should be allowed. The Advocate-General on the other hand argues that the assessee is entitled to an allowance on account of depreciation in buildings and machinery with reference to the price paid by it and in support of this contention he has placed reliance on the decision in Commissioner of Income-tax, Madras v. The Buckingham and Carnatic Company Ltd. Before this case was decided by their Lordships there was difference of opinion in India as to the true interpretation of the words "on the original cost thereof to the assessee" in Section 10 (2) (vi) of the Act. It was held by the Madras High Court in Commissioner of Income-tax, Madras v. Messrs. Massey & Co. Ltd., Madras, that the words quoted above meant the original cost to the vendor and not to the actual assessee, whereas the Bombay High Court in Commissioner of Income-tax, Bombay Presidency v. The Saraspur Mills Co., Ahmedabad, and the Patna High Court in Motiram Roshan Lal Coal Company Limited v. Commissioner of Income-tax, had held that those words meant the original cost to the actual assessee, viz., the purchaser. Their Lordships approved of the decisions of the Bombay and the Patna High Courts and held that "the cost which is to be considered for the purpose of the allowance for depreciation must be the original cost to the person by whom the income-tax is payable." It is however to be noted that neither in the case decided by their Lordships nor in the other cases referred to above did the question arise in relation to an assessment made under Section 26(2) of the Act and the case before us, is therefore, not governed by the decision of their Lordships.
The question that we have to decide formed the subject of decision by a Full Bench of the Bombay High Court in Commissioner of Income-tax, Bombay Presidency, Sind and Baluchistan v. Mazagaon Dock Ltd., Bombay. Beaumont, C.J., and Ranganekar, J., held that the "word "assessee" in Section 10 (2) (vi) in the case of an assessment under Section 26(2), based on the profits of a predecessor, must refer to such predecessor". The contrary view was however taken by Blackwell, J., who held that the word "assessee" in the said sub-section should be construed in its ordinary and natural meaning and read with its definition in Section 2 (2), it means the person by whom the income-tax is actually payable. Beaumont, C.J., and Rangnekar, J., have, in the course of their judgments, given reasons for holding that the decision of their Lordships referred to above does not deal with the question of assessment under Section 26 (2) the word "assessee" is interpreted as meaning the person by whom the income-tax assessed is actually payable and as we are in perfect agreement with the view expressed by them we adopt the reasons contained in their judgments.
It is clear that an assessment under Section 26 (2) is not made on the profits actually received by the successor referred to in that section and is at best a hypothetical or notional assessment. The assessment is made on the supposition that the whole of the profits for the "previous year" were received by the successor even though the whole or a part of those profits must have been received by his predecessor. In other words, the successor is, for the purpose of assessment under Section 26 (2), to be assumed as his predecessor with respect to the previous year and the profits have to be computed on this assumption. That being so, in the computation of the profits for the "previous year" deduction must be made with respect to all the allowance enumerated in sub-section (2) of Section 10 to which the predecessor may have been entitled.
The contrary view would lead to anomalous and startling results. That this is so may be illustrated by the following example :-
A carried on certain business in the year 1938-39 and the profits made by him, without making the allowance specified in Section 10(2), amounted to Rs. one lakh. On the eve of assessment with respect to 1939-40 on the profits for the previous year even though he did not receive any portion of those profits. If the contention advanced on behalf of the Department is well founded, in the computation of the profits for the previous year B will not be entitled to any of the allowances specified in sub-section (2) of Section 10 and he would not be entitled even to claim depreciation on the price paid by him for the transfer of the business in his favour for the simple reason that the ownership of the buildings, machinery etc., had not passed to him in the "previous year". In other words, he would be subject to the double penalty of paying income-tax on a supposed profit which he never received and further, in the computation of the taxable profit, the allowances to which A would have been entitled would be denied to him.
One can appreciate the reason for the legislature making the successor liable to pay tax on the profits of the previous year, but why should the fact of transfer entitle the Department to give a clear go by to the mandatory provisions of sub-section (2) of Section 10 in computing the profits for the "previous year" passes our comprehension. Section 26 (2) makes provision about the assessment of the profit of a "business" on a certain basis when it is found at the time of assessment that a "change of ownership of Business" has taken place. But this provision is subject to Section 10(2) of the Act. If you assess the successor on the profits received in the previous year you must, in the ascertainment of that profit, take into account all the allowances specified in subsection (2) of Section 10. In short for the purposes of notional assessment under Section 26(2) the assessee must be deemed to be his predecessor in the business and allowance for depreciation must be made on that basis.
For the reasons given above our answer to the first question is in the affirmative.
The answer to the second question depends on the interpretation of the sale deed in favour of the assessee. A perusal of that deed puts it beyond doubt that the consideration for the transfer of the Mills in favour of the assessee was only Rs. 11,12,000 and the losses incurred in the previous years, or the interest on the sums advanced to the liquidators by the assessee, or the interest on the capital invested by the assessee in the working of the Mills did not form the consideration for the sale. The amount of losses etc. cannot, therefore, be deemed to be a part of the consideration for the sale and as such, cannot be taken into account in determining the "original cost" to the assessee of the machinery and buildings. The answer to the second question is, therefore, in the negative.
As regards the third question it was not disputed on behalf of the Department that the two items mentioned in that question were spent in making additions to buildings and machinery. These items must, therefore, be taken into account in calculating the depreciation to which the assessee is entitled. The answer to the third question is accordingly in the affirmative.
As the assessee had substantially succeeded we allow to the assessee the costs of this reference which we assessee at a sum of Rs. 500. The fee of the counsel for the Income-tax Department is fixed at a sum of Rs. 200.
Reference answered accordingly.