Collusive payments to Directors is an unallowable expenditure

Homi P Ranina

UNDER section 37 of the Income-tax Act, 1961, any expenditure is deductible if it is incurred wholly and exclusively for the purposes of business. The judgment of the Supreme Court in Eastern Investments Ltd v CIT (20 ITR 1) establishes that in the absence of fraud, the questions whether a transaction had the effect of diminishing the assessee’s taxable income, whether it was a prudent or wise transaction, and whether it was necessary for the assessee to enter into that transaction, are irrelevant in determining whether expenditure relating to that transaction should be allowed under the head “Income from other sources”; and the same considerations apply under section 37.

Subba Rao J, speaking for the Supreme Court, observed as follows in CIT v Malayalam Plantations Ltd. (53 ITR 140) :

The true test of an expenditure laid out wholly and exclusively for the purposes of trade or business is that it is incurred by the assessee as incidental to his trade

HOMI P RANINA Advocate, Supreme Court

“The expression ‘for the purpose of the business’ is wider in scope than the expression ‘for the purpose of earning profits’. Its range is wide: it may take in not only the day to day running of a business but also the rationalization of its administration and modernization of its machinery; it may include measures for the preservation of the business and for the protection of its assets and property from expropriation, coercive process or assertion of hostile title; it may also comprehend payment of statutory dues and taxes imposed as a pre-condition to commence or for carrying on of a business; it may comprehend many other acts incidental to the carrying on of a business.”

The Delhi High Court considered the point of collusive payments to directors of a private company. In BK Khanna and Co Pvt Ltd v CIT (247 ITR 705), the assessee was a closely held private limited company with four directors.

For the assessment year 1966-67, the assessee claimed deduction of a payment made to two of its directors not to carry on any further business of promotion of companies for a period of five years.

The assessing officer disallowed the claim of the assessee on the ground that the amount could not be said to have been laid out wholly and exclusively for the purpose of the company’s business.

The tribunal found that the government by a letter had revoked the licence of industrial undertaking for the two directors. The letter indicated that the two directors were not in a position to promote new companies after revocation of the licences. It was held that the payments made to the two directors could not be allowed to the company as admissible deductions.

On a reference, the Delhi high court held that the directors were to some extent trustees for the company and to a certain extent they were agents. They stood in a fiduciary position towards the company. It was noticed by the tribunal that the assessee-company was a closely held company and all the four directors were closely related. There were two working directors, ie, male directors and the other two were ladies.

The payment was not for agreeing not to carry on any similar business but for carrying it on for the assessee-company.
The court found that the arrangement entered into between the company and the two directors was not only not bona fide but also of a collusive nature. It was, therefore, held that the amount was not deductible under section 37(1).

An analysis of section 37(1) shows that any expenditure, not being expenditure of the nature described in sections 30 to 36, not being in the nature of capital expenditure, or personal expenses of the assessee laid out or expended wholly and exclusively for the purposes of business or profession would be allowed in computing the income chargeable under the head “Profits and gains of business or profession”.

The word “wholly” refers to quantum of expenditure. The word “exclusively” refers to the motive, objective and purpose of the expenditure and gives jurisdiction to the taxing authorities to examine these matters.

The true test of an expenditure laid out wholly and exclusively for the purposes of trade or business is that it is incurred by the assessee as incidental to his trade for the purpose of keeping the trade going.

It has to be examined whether the expense has been incurred with the sole object of furthering the trade or business interest of the assessee unalloyed or unmixed with any other consideration.
If the expense is found to bear an element other than the trade or business interest of the assessee, the expenditure is not an allowable one.

In conclusion, it must be pointed out that expenditure of a collusive nature which is represented by excessive or unreasonable payments to directors, relatives and other associates is expressly disallowed under section 40-A(2) of the Act. This sub-section provides that where any payment is made to a relative as defined in section 2(41) or an associate specified in clause (b) of this sub-section and the assessing officer is of opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession, he is empowered to disallow so much of the expenditure as he considers excessive or unreasonable.

However, if the assessee sells goods at a discount and charges only a lower net price, he does not incur any “expenditure”.
Therefore, no disallowance under this sub-section can be made as held in CIT v Subbaraya (123 ITR 592) and CIT v Udhoji (139 ITR 27).