Commission paid to director cannot be allowed if no service been rendered

ITAT HYDERABAD BENCH ‘A’

Orient Longman (P.) Ltd.

versus

Joint Commissioner of Income-tax

IT Appeal Nos. 529 & 595 (Hyd.) of 2009
[ASSESSMENT YEAR 2005-06]

OCTOBER 19, 2012

ORDER

Saktijit Dev, Judicial Member

These cross-appeals-one by the assessee and the other by the Revenue-for the assessment year 2005-06 are directed against the order of the Commissioner of Income-tax (Appeals)-V, Hyderabad, dated February 27, 2009. Since common issues are involved, these appeals are being disposed of with this common order for the sake of convenience.

Assessee’s appeal :

I.T.A. No. 529/Hyd/2009 : assessment year 2005-06

2. Ground Nos. 1 to 3 of the assessee’s appeal relate to dis allowance of commission payment of Rs. 3,93,061 to non-whole time directors.

3. Briefly stated, the facts are that the assessee is engaged in the business of publishing and selling books. For the impugned assessment year, the assessee filed its return of income declaring income of Rs. 3,67,70,240. The return filed by the assessee was picked up for scrutiny by issuing notice under section 143(2) of the Act. In the course of scrutiny, the Assessing Officer noticed that the assessee has claimed expenditure of Rs. 3,93,061 towards commission to non-whole time directors. The Assessing Officer further noticed from the annual report that commission to directors was paid as a percentage of net profit. The Assessing Officer therefore, requested the assessee to furnish the agreement with the directors, the details of services rendered by the directors, and whether such services were covered by the terms of employment. In response to the query made by the Assessing Officer, the assessee submitted that the commission payment to non-whole time directors was approved by a resolution of the Board and as per the provisions of the Companies Act, 1956. The assessee further clarified that no agreement was entered into with the directors in respect of commission payment. The Assessing Officer, after examining the Board’s resolution, was of the view that the non-whole time directors had no contract of employment with the company. Therefore, the commission, not being contractual, its allow ability has to be considered as per the provisions of section 37 of the Income-tax Act. The Assessing Officer observing that the assessee has failed to bring any material on record to prove that the non-whole time directors have rendered any services which resulted in the improvement of business of the assessee, opined that the commission paid as a percentage of net profit is nothing but distribution of profit. The Assessing Officer holding that there being no material to show that the commission payment was wholly and exclusively for the purposes of business, disallowed the same, and added it to the income of the assessee.

4. The assessee challenged the addition by filing appeal before the Commissioner of Income-tax (Appeals). Before the Commissioner of Income-tax (Appeals), the assessee contended that the term “salary” under the Income-tax Act as well as the Companies Act includes commission. The payment of commission having been worked out as per the provisions of the Companies Act, 1956 and is authorized by the board and approved by the members cannot be disallowed. The assessee contended that the board of directors take crucial decisions collectively and are collectively responsible for the growth of the company, and therefore, it is not for the Assessing Officer to evaluate their services for the company. The assessee further contended that the commission payment is an expenditure wholly and exclusively for the purposes of the company, and therefore, it is allowable. The Commissioner of Income-tax (Appeals), came to the conclusion that the assessee has not submitted any evidence to prove that the non-whole time directors have actually rendered services, which has resulted in enhancement of profit of the company during the relevant previous year. The Commissioner of Income-tax (Appeals), following the decision of the Honorable Supreme Court in the case of Swadeshi Cotton Mills Co. Ltd. v. CIT [1967] 63 ITR 57 held that the assessee having failed to prove regarding rendering of services by the non-whole time directors in real terms, which resulted in improving the profitability of the company, payment of commission cannot be allowed as expenditure.

5. The learned authorized representative for the assessee while making his submissions virtually reiterated the stand taken before the lower authorities. The learned authorized representative for the assessee submitted that the term “salary” as provided in section 15 of the Act, also includes commission. The learned authorized representative for the assessee submitted that the board of directors take crucial decisions collectively and also responsible for the growth of the company. Therefore, the payment of commission as a percentage of profit, having been approved by the board cannot be disallowed.

6. The learned Departmental representative submitted that the assessee since has failed to provide any evidence to prove the fact that the payment of commission was wholly and exclusively for the purpose of business, the dis allowance of expenditure was justified. He therefore, urged for sustaining the addition.

7. We heard rival submissions and perused the materials on record. It is seen from the material on record that there is no contract of employment between the assessee- company and non-whole time directors. They were also not paid any fixed remuneration. The Board’s resolution dated May 15, 2002, which has been extracted in the impugned order of the Commissioner of Income-tax (Appeals) provides for payment of remuneration/ commission not exceeding one per cent. of the net profit of the company. The resolution does not however, fix any particular service, for the performance of which commission is paid to non-whole time director. The assessee has not produced any evidence before the lower authorities, to show that the commission was paid for rendering any service, which resulted in enhancing the profitability of the company. The learned authorized representative for the assessee apart from submitting that commission was paid as per the collective decision of the board, and in terms with the provisions of the Companies Act, 1956, has not produced any evidence to prove that the non-whole time directors have rendered any service, for which commission was paid. Payment of commission cannot be allowed as an expenditure simply because, it is approved by the board and it is in accordance with the provisions of the Companies Act, 1956. An expenditure which falls within the ambit of section 37 of the Act can be allowed, if it is incurred wholly and exclusively for the purpose of business. In the present case, the assessee has failed to prove that the expenditure incurred was wholly and exclusively for the purpose of business. In the aforesaid view of the matter, we are not inclined to interfere with the view taken by the lower authorities, which is accordingly sustained, and the grounds of the assessee on this issue are rejected.

8. Grounds Nos. 4 to 7 of the assessee in its appeal are in respect of addition of an amount of Rs. 45 lakhs on account of under valuation of closing stock.

9. Briefly the facts are that the assessee for the assessment year under dispute valued the closing stock at Rs. 4,23,61,003. In the notes to the accounts, the assessee mentioned that the closing stock of books is generally shown at realizable value because of various factors. It is further mentioned that the management has formulated and standardized the method for identifying slow and non-moving stock of books for the purposes of valuation of closing stock. The Assessing Officer asked the assessee to furnish the working of the closing stock by giving the following details-

(a) Actual cost of books included in the closing stock.

(b) Amount shown in the profit and loss account

(c) In case actually there is a change in syllabus with respect to such books which have been included in the closing stock, work out the actual cost and realizable value separately.

The assessee replied explaining the position as to the valuation of the closing stock in the following manner-

“The closing stock is valued as explained earlier in the previous years and expected future sales. Out competitors tried to add new chapters to get their books prescribed stating that their books is better than others. To withstand such competition, there is need to add new chapter for us as well. Once a new chapter is added the old books becomes redundant. While assessing future sales, we look into the factors which influence the future sales such as :

1. Change in syllabi

2. Competitors titles

3. Piracy

4. No/slow moving titles

5. Change in education policy

6. Political uncertainty, etc.

Taking all these factors into account, the valuation of stock is done. This is the method generally followed in the publishing industry world over and in the same method followed by us.

The actual stock as on March 31, 2005 for all our 3121 titles is 69,06,786 copies. The titles considered for valuation based on the factors stated above are 2445 and the copies considered for valuation are 63,28,674.

There was no sale in 2004-05 for 675 titles printed about 2 years back and therefore we have not considered stock representing to these titles for valuation.”

10. The Assessing Officer was not convinced with the explanation of the assessee. As the assessee did not furnish the details with the titles, which were considered by the assessee as redundant and as to how they were valued. The Assessing Officer was of the view that the valuation done by the assessee is purely provisional and based on contingent event like anticipating competition from competitors, change in syllabi, political uncertainty, etc. the realisable value has been arrived at by the assessee, by heavily banking on the uncertain contingent event in general term. The Assessing Officer came to a conclusion that the closing stock has been valued at a lesser value proceeded, to make a fresh valuation of the closing stock by adopting his own method, as below-

11. The Assessing Officer held that the assessee has undervalued the stock to the extent of Rs. 75,36,842 and added the same to the total income.

12. The assessee challenged the addition by filing appeal before the Commissioner of Income-tax (Appeals). Before the Commissioner of Income-tax (Appeals), it was submitted by the assessee that it was following the same method of valuation consistently from year to year. The books printed and published is generally far in excess of the annual sale requirement. Later editions of the same books are also printed from time to time after carrying out editorial and other changes. It was submitted that many of the standard books conforming to the syllabi of various universities also become redundant due to change in syllabi. It was submitted that excepting in cases where the books are printed during the year end, the value of inventory is equal to scrap value of the books. Therefore, taking all these factors into consideration on a title to title basis, the valuation of stock is made based on past years’ sales as well as expected future sales. The stock of each title is verified and value evaluated on a title-wise basis for the entire inventory. It was further submitted that the assessee is valuing its closing stock at the year end by applying a formula which has been followed by the assessee consistently. The formula followed by the assessee for valuation of closing stock is—

“(1) If stock in hand as on 31st March pertains to the current year’s printing, the stock is valued at 75 per cent. of the current year’s printing.

(2) If the stock in hand includes/pertains to the previous year’s stock, the stock is valued at 25 per cent. of the previous year’s printing.

(3) If the stock in hand includes/pertains to the stock printed over two years but less than three years, the stock pertaining to over two years will be valued at 15 per cent. of the previous year’s printing.

(4) In addition, proportionate direct expenses pertaining to the full salaries of our production personnel and fifty per cent. of the salaries of our editorial personnel are taken into account while arriving at the valuation of our stock.”

13. It was submitted by the assessee that a rider to the formula adopted for valuation of stock is that the stock quantity of each title is restricted to sales quantity for that title in the year. If, in case of a particular title, the stock quantity is more than the year sales quantity, then the stock quantity of that title is restricted to the sales quantity of that title in the year. In support of the contention, the assessee submitted before the Commissioner of Income-tax (Appeals) a consolidated stock valuation statement as on March 31, 2005. The Commissioner of Income-tax (Appeals) after considering the submission of the assessee and examining the materials on record found that the assessee has advanced an altogether different argument before him, while clarifying on valuation of stock. Before the Assessing Officer, the assessee had stated that actual stock as on March 31, 2005 is for 3,121 titles numbering 69,06,786 copies, out of which the assessee has considered 63,28,624, covering 2,445 titles for valuation, and rest 675 titles were not considered for valuation as they were printed about two years back and there were no sales during the year. However, before the first appellate authority, the assessee submitted that in respect of stock pertaining to the current year’s printing, valuation is made at 75 per cent. of the cost, stock arising from printing made in preceding previous year is valued at 25 per cent. of the cost, and in respect of cost arising out of printing made more than two years but less than three years back is valued at 15 per cent. of the cost price. Furthermore, for the purpose of valuation, the stock quantity of each title cannot exceed the sale quantity of that title during the previous year. The Commissioner of Income-tax (Appeals) found that even though the assessee himself has devised the method of valuation of closing stock at 75 per cent. of the cost, but as a result of the rider put by it, the actual value of the stock is reduced. That apart, the assessee never revealed that method of valuation before the Assessing Officer.

14. The Commissioner of Income-tax (Appeals) noticed that in case of certain titles, like “Allauddin and Other Tales”, “Robinson Crusoe” and “A Tale of Two Cities”, while valuing the closing stock, the assessee has taken lesser number of books than what has been printed during the current previous year and actually lying in stock. In respect of eight titles under the name, “A Magic Place Teacher’s Book”, though the entire stock arises from current previous year’s printing, but while valuing the closing stock, not a single piece has been taken into account. The Commissioner of Income-tax (Appeals) also noticed that before the Assessing Officer, the assessee has submitted that the assessee has considered 63,28,674 copies covering 2,445 titles for the purpose of valuation of closing stock arrived at Rs. 4,23,61,003. However, in the consolidated stock statement furnished at the first appellate stage, the closing stock valuation of Rs. 4,23,61,003 was shown to be for 26,18,572 number of books. Due to the aforesaid differences and discrepancies, the Commissioner of Income-tax (Appeals) held that the valuation of closing stock made by the assessee cannot be accepted, and to arrive at the value of the closing stock, estimation has to be made. The Commissioner of Income-tax (Appeals) further did not consider the method adopted by the Assessing Officer to value the closing stock to be proper, since the Assessing Officer has presumed that the opening stock of goods, are still lying with the assessee and the remaining closing stock alone is out of the current year’s production. The Commissioner of Income-tax (Appeals) also held that the Assessing Officer was not justified in adopting the average price of Rs. 4.28 in respect of opening stock and average price of Rs. 6.13 in respect of the closing stock when the stock with the assessee comprises of titles having different prices. The Commissioner of Income-tax (Appeals) finally estimated the undervaluation of closing stock at Rs. 45 lakhs, and directed the Assessing Officer to restrict the addition made by him on this account to this figure.

15. Aggrieved by the relief granted by the Commissioner of Income-tax (Appeals), the Revenue raised grounds on this issue in its appeal, whereas the assessee is in appeal not satisfied with the relief granted and aggrieved by the addition sustained.

16. The learned authorized representative, reiterating the stand taken before the first appellate authorities submitted before us that due to various factors like change in syllabi, competitors’ titles, piracy, change in education policy, etc., the stock of books which are printed about two years back have absolutely no value and rather they are as good as scrap. Therefore, they are not considered for valuation of stock. The learned authorized representative submitted that the assessee has, therefore, devised a formula for valuation of closing stock, which is being consistently followed by it from year to year and the formula adopted by the assessee for adopting the valuation of closing stock is generally followed in the publication industry and it is also as per the Accounting Standards. The learned authorized representative submitted that the closing stock valued by it by applying the aforesaid method in previous assessment years and subsequent years has been accepted by the Department. The learned authorized representative, therefore, urged for accepting the valuation of closing stock made by the assessee.

17. The learned Departmental representative submitted before us, that the assessee has deliberately undervalued the stock, the difference in valuation worked out by the Assessing Officer has been rightly added to the income of the assessee. As such, the Commissioner of Income-tax (Appeals) was not justified in granting any relief to the assessee, and therefore, the addition thus made by the Assessing Officer should be restored.

18. We have heard the rival submissions and perused the materials on record. After going through the orders of the lower authorities, we find it quite clear that the assessee has taken a prevaricated stand with regard to the valuation of closing stock. While before the Assessing Officer, the assessee has stated that it has considered for valuation 2,445 titles running into 63,28,674 copies for valuation, and it has not considered 675 titles printed about two years back, before the Commissioner of Income-tax (Appeals), the assessee has submitted a different method of valuation, as per which stocks relating to current year’s printing is valued at 75 per cent. of the cost, stock relating to previous year’s printing is valued at 25 per cent. of the cost, and the stock relating to more than two years back is valued at 15 per cent. of the cost. The assessee has prescribed further rider that stock quantity of different titles is restricted to sale quantity of that title in the year. It is also a fact that before the Assessing Officer, the assessee has stated the valuation of 63,28,674 copies at Rs. 4,23,61,003, whereas in the consolidated stock statement, the assessee has shown 26,18,572 copies for valuation of closing stock at the same figure of Rs. 4,23,61,003. The Commissioner of Income-tax (Appeals) has also referred to specific instances of titles, which though were printed during the current year, while valuing the closing stock, the assessee has taken lesser number of books than what is actually available in stock. In the case of the title “A Magic Place Teacher’s Book”, though the entire stock was printed during the current previous year, while valuing the closing stock, the assessee has not considered even a single piece. This is in contradiction to the formula devised by the assessee himself for the valuation of closing stock. The aforesaid facts cast a doubt on the valuation of closing stock made by the assessee. Further, the contention of the assessee to the effect that the titles printed two years back and lying in stock have absolutely no value due to change of syllabi, appears to have some force. These books certainly cannot be sold in the market. The assessee may not be able to sell these books and can only treat them as scrap. The contention of the learned authorised representative for the assessee that the assessee is consistently following the same method of valuation of closing stock, which has also been accepted by the Department in the earlier as well as the subsequent years also requires to be considered. The Assessing Officer in the assessment order accepts the fact that the method of accounting followed by the assessee is not questioned. The Commissioner of Income-tax (Appeals) has also not given any basis for estimating the undervaluation of closing stock at Rs.45 lakhs. There is nothing in the order of the Commissioner of Income-tax (Appeals) to suggest why he has adopted the figure of Rs. 45 lakhs. The assessee however is required to substantiate with supporting evidence, which are the stocks lying with it, which are not considered for the purposes of valuation, and the reason for doing so. The assessee also had to explain the specific instances pointed out by the Commissioner of Income-tax (Appeals), where the assessee has taken into consideration lesser number of books for valuation of closing stock from the current year’s printing, when the assessee himself has adopted a formula, as per which the current year’s printing is valued at 75 per cent. of the cost. The assessee is also required to reconcile the discrepancy between the number of copies considered for arriving at the closing stock figure of Rs. 4,23,61,003 as per the consolidated stock statement submitted before the Commissioner of Income-tax (Appeals) and the details given before the Assessing Officer.

19. For the aforesaid reasons, we deem it proper to set aside the impugned order of the Commissioner of Income-tax (Appeals) and remit the matter to the file of the Assessing Officer for fresh determination of the issue relating to valuation of closing stock. The Assessing Officer shall consider this issue afresh in accordance with law, after giving reasonable opportunity to the assessee to substantiate its claim with regard to the value of the closing stock, duly reconciling the differences and discrepancies pointed out by the Commissioner of Income-tax (Appeals), as noted above, and in accordance with law.

20. In the result, the assessee’s appeal is partly allowed for statistical purposes.

The Revenue’s appeal I. T. A. No. 595/Hyd/2009

21. The only grievance of the Revenue in this appeal, as already noted above, relates to the relief granted by the Commissioner of Income-tax (Appeals) in the matter of the addition made by the Assessing Officer on account of the valuation of closing stock. In view of our decision on this very issue while dealing with the grounds of the assessee in relation to this very issue, whereby we have set aside the issue to the file of the Assessing Officer for fresh adjudication in accordance with law, after giving a reasonable opportunity of hearing to the assessee, the grounds of the Revenue in this appeal need no separate adjudication, and they are also treated as allowed for statistical purposes.

22. In the result, the Revenue’s appeal is allowed for statistical purposes.

23. To sum up, while the assessee’s appeal, I.T.A. No. 529/Hyd/2009, is partly allowed for statistical purposes, the Revenue’s appeal, I.T.A. No. 595/Hyd/2009, is allowed for statistical purposes.