The Hindu Business Line : Illegality or irregularity?

THE INCOME-TAX law has often been described as a confluence of laws. Company law, partnership law, Hindu law and a host of other enactments have a bearing on the interpretation and application of the tax code. Company law provisions will have to be understood in relation to claims for deduction of business expenditure.

Payments to directors and their relatives for services rendered are either prohibited or regulated under company law. It often becomes difficult for the authorities to decide whether a certain claim for payment as business expenditure is absolutely prohibited under company law or merely regulated, that is, allowed on following prescribed procedures.

Consider the following case. A UP-based company paid agency commission to its two selling agents. The board of directors had approved the appointment of the firms as selling agents. The commission was payable at 1 per cent of sales. The partners in the two selling agency firms were either directors or relatives of directors of the private limited company.

The assessing officer (AO) disallowed the claim for deduction of agency commission on the ground that it was a sole selling agency agreement which was not ratified at the first AGM of the company held after the execution of the contract and was therefore void ab initio in terms of Section 294 (2) of the Companies Act, 1956. He also held that the agreement was hit by Section 314(1)(b) of the Companies Act. He, therefore, disallowed the claim for deduction of the commission as business expenditure under Section 37 of the I-T Act. As the Income-Tax Appellate Tribunal (ITAT) had decided the matter in favour of the company, the Revenue took the case before the Allahabad High Court.

It was argued for the Revenue that mention of the phrase `sole selling agent' was not necessary in the agreement to determine whether the selling agent was a sole selling agent or not. The agency can be exclusive either with reference to territory or different types of products in a given territory. In any event, the selling agency agreements amounted to the enjoyment of an office of profit under Section 314 of the Companies Act.

If the payments contravened the Companies Act, they would have to be disallowed even if they were incurred as a trader, and the income-tax officer (ITO) was not bound to consult the Registrar of Joint Stock Companies or any other authority under the Companies Act for making the disallowance.

On the other hand, the company pleaded that there was no selling agency and that bona fide agreements were entered into in the interest of business and the claim was allowable under Section 37. All that the ITO should look into was whether services were, in fact, rendered and, if so, the expenditure to be allowed under Section 37. It was also pleaded that Section 314 did not cover selling agent.

The Allahabad High Court ruled that there was no definition of the term `sole selling agent' under company law and that there was nothing on record to show that the Central Government had declared any one of the two selling agents as the sole selling agent of the company.

Thus, the two firms cannot be treated as sole selling agents. The contract in question appeared to be grant of contract of appointment as distributor of the products and this did not require approval in the company's AGM. It was outside the scope of Section 294 of the Companies Act.

On the other hand, the words "office or place of profit" in Section 314(1) include selling agents receiving commission or salary. The sole selling agency represented an office of profit. The two firms which were appointed as selling agents consisted of either the directors or their relatives as partners and a special resolution was required to be passed by the company for their appointment. The appointment was hit by Section 314. The High Court held that the claim for deduction of commission to the two agency firms cannot be allowed under Section 37 (CIT vs R. K. Arkay Wires P. Ltd — 2005 277 ITR 225 Allahabad).

The payment in question arose out of a contract. Company law requires regulation of payment by proper approvals. There can be a debate on the question whether there is an absolute prohibition for payment of contractual liabilities under company law.

Law always recognises two categories of offences, namely, mala in se and mala prohibita. It is debatable whether the payments in question before the Allahabad High Court were mala prohibita.

(The author is a former Chief Commissioner of Income-Tax.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
The rupee flux

Illegality or irregularity?

There's a new ghost in the guest house

A bug in software service

An encroachment into space and time

What goes up must come down

What is writ in tax matters?

Thoughts on a quake