Kerala H.C : Whether Expln. 3 to s. 43(1) is attracted to the facts and circumstances of the case?

Counsel Appeared

P.K.R. Menon & N.R.K. Nair, for the Applicant : C. Kochunni Nair & Dale P. Kurian, for the Respondent

JUDGMENT

P.A. MOHAMMED, J. :

This batch of IT Ref. Cases at the instance of the Revenue relate to the asst. yrs. 1986-87, 198788, 1988-89 and 1989-90. IT Ref. Nos. 92 and 93 of 1995 arise from ITA Nos. 278/Coch/89 & 801/Coch/92 relating to the asst. yrs. 1986-87 and 1987-88 and IT Ref. Nos. 112 and 113 of 1996 arise from ITA Nos. 913/Coch/90 and 507/Coch/91 relating to the asst. yrs. 1988-89 and 1989-90. The common question referred to us for decision is: “Whether, on the facts and in the circumstances of the case, the assessee is entitled to claim depreciation on the assets taken over from the partnership firms at the revalued figure?”

An additional question has been referred to us for decision in IT Ref. Nos. 112 and 113 of 1996, which is as follows: “Whether Expln. 3 to s. 43(1) is attracted to the facts and circumstances of the case?”

The facts of the case are condensed thus: The assessee is a company known as “M/s Poulose & Mathan Pvt. Ltd.” engaged in the business of purchasing raw carbon dioxide and bottle it in cylinders after purification. The assessee was a partner in a partnership firm consisting of nine partners. The other eight partners were the shareholders of the assessee-company. The partnership firm was dissolved on 25th Feb., 1985 and the assets and liabilities of the firm were taken over by the assessee-company. The written down value of the assets of the firm was Rs. 3,16,110. However, the assets were revalued at a figure of Rs. 22,30,795 and claimed depreciation on the aforesaid amount. However, the AO did not allow depreciation on the enhanced value of assets for the years 1986-87 and 1987-88. For the asst. yr. 1988-89 and 1989-90 also the AO disallowed similar claim for depreciation. The appeals were filed before the CIT(A) as against the orders of the AO. The CIT(A) also disallowed the claim and thereby the orders of the assessing authority were upheld. In second appeal, the Tribunal held that the assessee was entitled to depreciation on the enhanced value of assets as revalued. The Tribunal further found that the revaluation of the assets was bona fide for adjustment of the mutual rights of the partners and Expln. 3 to s. 43(1) of the Act was not applicable to the facts of the case. Being aggrieved by the orders passed by the Tribunal the Revenue filed application for reference before the Tribunal in respect of all the assessment years.

The following questions of law were raised for reference in respect of the asst. yrs. 1986-87 and 1987-88.

“1. Whether, on the facts and in the circumstances of the case : i) the assessee is entitled to claim depreciation on the assets ‘taken over’ from the partnership firms at the revalued figure; (ii) was there ‘taken over’ of assets by the assessee from the partnership firm? iii) are not the reconstitution, dissolution, taken over and the revaluation etc. a design or device to reduce the tax liability? 2. Whether, on the facts and in the circumstances of the case and also on a consideration of the terms with reference to dissolution of the firm in the last reconstitution of the firm evidenced by an instrument dt. 1st Sept., 1985 and comparing the same with the terms in the earlier deed or deeds of reconstitution earlier effected is not the reconstitution dt. 1st Sept., 1985 and the immediate dissolution on 25th Feb., 1985 only a ruse or design or device to reduce the tax liability by setting up the claim for higher amount of depreciation on the enhanced value of assets and is not the order of the Tribunal also vitiated for not considering intention or design in the light of the above instruments?3. Whether, on the facts and in the circumstances of the case : is not the admission of the assessee-company as a partner and the subsequent dissolution of the partnership deed hit by Expln. 3 to s. 43(1) of the IT Act? 4. Whether, on the facts and in the circumstances of the case and also on a consideration of the terms in the deed of reconstitution dt. 1st Sept., 1985 and the earlier deeds of reconstitution, the Tribunal is right in law and fact in holding that ‘the revaluation of the assets on the eve of the dissolution of the firm was with a view bona fidely done for the adjustment of mutual rights of the partners in the partnership firm’ and is not the above finding wrong, baseless against the principles laid down in CIT vs. Meenakshi Mills (1967) 63 ITR 609 (SC) and McDowell and also against reality, human conduct and commonsense? 5. Whether, on the facts and in the circumstances of the case and also in the light of the principle laid down in Meenakshi Mills (supra) the reasoning and findings of the Tribunal in paragraph 11 of the order is correct and valid? 6. Whether, on the facts and in the circumstances of the case and also on a consideration of the submissions of the Revenue noted in paragraphs 12 and 13 of the order and also on a consideration of the terms in the reconstituted deeds and the dissolution deed, the Tribunal is right in law and fact in holding that the transactions are bona fide and real and are not the findings against the dictum and procedure laid down in Meenakshi: “But in certain exceptional cases the Court is entitled to lift the veil of corporate entity and to pay regard to the economic realities behind the legal facade”? 7. Whether, on the facts and in the circumstances of the case and taking into account the major submissions of the Revenue in the case, the Tribunal is right in law in holding that ‘the argument that the payments were made from out of the depreciation is not available to the Revenue’ and is not the above finding wrong and lacks perspective? 8. Whether, on the peculiar facts and peculiar circumstances of this case, on the eve of the dissolution of the partnership firm could its assets be factually and legally revalued at a figure of Rs. 22,38,795 as against the written down value of Rs. 3,16,110? 9. Whether, on the facts and in the circumstances of the case, the Tribunal is right in law and fact in holding that the amount of Rs. 1,91,468 to be exact, the sum of Rs. 2,11,588 cannot be deducted from the value of the assets acquired?” Likewise, in respect of the asst. yrs. 1988-89 and 1989-90 the questions of law raised for reference were the following:

“1. Whether, on the facts and in the circumstances of the case, the Tribunal is right in holding: the company was originally formed by taking over all the assets and liabilities of the erstwhile firm, M/s Poulose & Mathen in which the assessee was a partner and is not the above finding legally and factually wrong?

2. Whether, on the facts and in the circumstances of the case, (i) the assessee is entitled to claim depreciation on the assets ‘taken over’ from the partnership firm at the revalued figure; (ii) was there ‘taken over’ of assets by the assessee from the partnership firm? (iii) are not the reconstitution, dissolution, taken over and the revaluation etc. a design or device to reduce the tax liability? Whether, on the facts and in the circumstances of the case and also in the light of the principles laid down in Meenakshi Mills (supra) the reasoning and conclusion of the Tribunal are valid and in accordance with law? Whether, on the facts and in the circumstances of the case and considering the difference in facts noted by the Tribunal in paragraph 7 of the order (in the matter of the take over of assets by the assessee from M/s Poulose & Mathen and from M/s Power Traction Co.) (i) the Tribunal is legally and factually right in its present consistent order; (ii) will not the conclusion of the Tribunal in paragraph 7 (dealing with power Traction Co.) militate against the view in paragraph 3 (dealing with M/s Poulose & Mathen)?

5. Whether, on the facts and in the circumstances of the case and after having found (in the case of M/s Power Traction Company) ‘Therefore, it cannot be said that the assessee just purchased the asset at a higher value for the purpose of claiming higher amount of depreciation and this attracted the provisions of Expln. 3 to s. 43(1) of the IT Act” should not the Tribunal have taken a contrary decision in paragraph 3 while dealing with M/s Poulose and Mathen – “a case of just purchased’ and is not the above finding bereft of any sanctity in view of the consistent finding on inconsistent and divergent facts? Whether, on the facts and in the circumstances of the case and in the light of Meenakshi, the assessee is entitled to depreciation on the enhanced value? Whether, on the facts and in the circumstances of the case did Expln. 3 to s. 43(1) of the IT Act, applied to the facts of the case?”

Since the Tribunal has rejected the reference applications, the Revenue filed OP Nos. 3103 of 1994 and 17982 of 1993 before this Court in respect of the years 1988-89 and 1989-90 under s. 256(2) of the Act. After hearing, this Court directed the Tribunal to refer the questions of law quoted in the judgment. In respect of the years 1986-87 and 1987-88 also the Revenue approached this Court and this Court directed the Tribunal to refer the question of law quoted in the judgment dt. 21st Oct., 1994 in OP Nos. 15948 and 16707 of 1993. While directing to refer the above questions, this Court observed that those questions would cover all the aspects of the case which the Revenue had raised in its reference application. Therefore, what we propose to do is to answer the questions referred to us by the Tribunal pursuant to the direction of this Court in OP Nos. 15948 and 16707 of 1993 relating to the years 1986-87 and 1987-88 (IT Ref. Nos. 92 and 93 of 1995) and OP Nos. 17982 of 1993 and 3103 of 1994 relating to the years 1988-89 and 1989-90 (IT Ref. Nos. 112 and 113 of 1996).

Let us examine as to how the AO has completed the first assessment relating to the year 198687 which contains all the material particulars for taking decision in these cases. While arriving at a loss of Rs. 9,84,906 the company has claimed depreciation amounting to Rs. 10,06,657 for the asst. yr. 1986-87. The total value of assets taken over by the firm M/s Poulose & Mathen was Rs. 22,35,540. There were eight partners in the said firm and they were members of the families of Poulose & Mathen. As per the terms of the partnership deed dt. 1st Sept., 1984 the assesseecompany was admitted as a partner with 10 per cent share. The firm was dissolved on 25th Feb., 1985 and all the assets and liabilities of the firm were taken over by the assessee company. All the remaining partners had been allotted shares in the company. Thus, the shareholders of the company were the partners of the erstwhile firm. As per the account books of the firm, written down value as on 31st Dec., 1984 was Rs. 3,16,110. After the company had taken over the assets of the firm after its dissolution, the assets were revalued as on 25th Feb., 1985 at Rs. 22,30,795. The assessee-company claimed depreciation on the value of Rs. 22,30,795 as per the revised valuation of the assets. The AO came to the conclusion that the main purpose of the dissolution of the firm and transferring the assets and liabilities to the company was only with a view to reduce the liability to income-tax by claiming depreciation with reference to the enhanced cost of the company. Therefore, he took the view that Expln. 3 to s. 43(1) should be adopted. Accordingly the AO calculated depreciation on the basis of the total value of the assets namely Rs. 3,16,110 and disallowed the claim for depreciation of Rs. 22,30,795. Explanation 3 to s. 43(1) is as follows: 43. Definitions of certain terms relevant to income from profits and gains of business or profession.— In ss. 28 to 41 and in this section, unless the context otherwise requires— (1) “actual cost” means the actual cost of the assets to the assessee, reduced by that portion of the cost thereof, if any, as has been met directly or indirectly by any other person or authority: Explanation 3—Where, before the date of acquisition by the assessee, the assets were at any time used by any other person for the purposes of the business or profession and the AO is satisfied that the main purpose of the transfer of such assets, directly or indirectly to the assessee, was the reduction of a liability to income-tax by claiming depreciation with reference to an enhanced cost, the actual cost to the assessee shall be such an amount as the AO may, with the previous approval of the Dy. CIT, determine having regard to all the circumstances of the case.” What is ‘actual cost’ contemplated under s.43? It means the actual cost of the assets to the assessee, reduced by that portion of the costs met by other person or authority directly or indirectly. The prefixure of the word ‘actual’ to the word ‘cost’ is obviously intended to make emphasis on the reality and genuineness thereof. The fixation of ‘actual cost’ arises only when the AO is satisfied that the main purpose of the transfer of the assets which were used by any other person at any time for the purpose of his business or profession, directly or indirectly to the assessee was the reduction of a liability to income-tax by claiming depreciation with reference to an enhanced cost. When the AO is so satisfied, he had wide discretion to fix the ‘actual cost’ having regard to all the circumstances of the case subject to the previous approval of the Dy. CIT.

The Supreme Court in Sunil Siddharthbhai vs. CIT (1985) 49 CTR (SC) 172 : (1985) 156 ITR 509 (SC) : TC 20R.900, was examining a case of transfer of assets within the terms of s. 45 of the Act. In this context, the apex Court has laid down the scope of the powers of the AO and said: “he is entitled to penetrate the veil covering it and ascertain the truth”. What is required to be examined is whether the transaction of creating the partnership is a genuine or sham transaction and, even where the partnership is genuine, the transaction of transferring the personal asset to the partnership firm represents a real attempt to contribute to the share capital of the partnership firm for the purpose of carrying on the partnership business or is nothing but a device or ruse to convert the personal asset into money substantially for the benefit of the assessee while evading tax on a capital gain.

The Expln. 3 to s. 43(1) corresponds to s. 10(5)(a) of the 1922 Act. Sec. 10(5)(a) came up for interpretation before the Andhra Pradesh High Court in Kungundi Industrial Works Pvt. Ltd. vs. CIT (1965) 57 ITR 540 (AP) : TC 29R.466. There the Court held to the following effect: “…that the increase in value of the assets was substantial and out of all proportion to the written down value in the hands of the previous assessee.

The reasons advanced for the change-over did not justify the increase in value of assets. The main purpose of the change-over was, therefore, the reduction of liability to income-tax by claiming depreciation with reference to enhanced costs and the first proviso to s. 10(5)(a) would apply. The ITO had power to determine the actual cost of the assets with the previous approval of the IAC”.

Counsel for the Revenue submitted that the principle laid down in the above decision would squarely apply to the present case inasmuch as the facts are more or loss identical. There the partners of a firm constituted themselves into a private limited company. The shareholders of the company were the old partners and their nominees and shares in the company were allotted in the same proportion as shares held by the partners in the firm. At the time of the change-over the company valued assets received from the firm at Rs. 63,000 and Rs. 87,000 while their written down value in the hands of the firm was Rs. 3,994 and Rs. 13,210 respectively. The company claimed that the reasons for the change-over were efficient working of the concern, due control over its members and preservation of rights of some of its opulent members. The company claimed depreciation allowance on its assets on the basis of their enhanced value as shown in its books. In the aforesaid factual background the Court observed: “But this much is certain that the inflation has become possible on account of the change-over. The question then in these circumstances is, whether the main purpose for the change-over or transfer of assets to the assessee was directly or indirectly the reduction of a liability to income-tax by claiming depreciation with reference to an enhanced cost. If that be inferred from the circumstances, the matter would be governed by the proviso to s. 10(5)(a). It must be borne in mind that for the application of the proviso that need not be the only reason for the change-over or transfer of assets. There may be other reasons also but the main purpose should be the reduction of liability to income-tax directly or indirectly by claiming depreciation on enhanced value”. (Emphasis, italicised in print, supplied)

9. The AO has no grievance against the revaluation of the assets done by the approved valuer. The Tribunal however observed that his grievance was that it was done with a view to reduce tax liability. It is an admitted case that the revaluation of the assets was made on 25th Feb., 1985 and on the same day the firm was dissolved. The written down value in the books of accounts of the firm as on 31st Dec., 1984 was Rs. 3,16,110 whereas the value of the assets as per revaluation was Rs. 22,30,795. On behalf of the assessee it was pointed out that in the event of dissolution of a partnership firm true account of all assets and liabilities should be taken in order to adjust the mutual rights of the partners in the partnership property. In support of this proposition the decision of the Supreme Court in A.L.A. Firm vs. CIT (1991) 93 CTR (SC) 133 : (1991) 189 ITR 285 (SC) : TC 2R.453, was relied on. The Tribunal highlights the following passage from Pickles on Accountancy (Third Edn.) as quoted in the above decision of the Supreme Court at page 650 of the report. “In the event of the accounts being drawn up to the date of death or retirement, no departure from the normal procedure arises, but it will be necessary to see that every revaluation required by the terms of the partnership agreement is made. It has been laid down judicially that, in the absence of contrary agreement, all assets and liabilities must be taken at a ‘fair value’ not merely a ‘book value’ basis, thus involving recording entries for both appreciation and depreciation of assets and liabilities. This rule is applicable, notwithstanding the omission of a particular item from the books, e.g. investments, goodwill [Cruikshank vs. Sutherland (1922) 92 LJ Ch 136 (HL)]. Obviously, the net effect of the revaluation will be a profit or loss divisible in the agreed profit or loss-sharing ratios”. This is a well known principle of accountancy and we have no manner of dispute as to its applicability in taking accounts for purposes of dissolution. No doubt the firm and partners being commercial men would value the assets only on a real basis and not at costs or at their other value appearing in the books. Therefore, it is all the more certain that the real rights of the partners cannot be mutually adjusted on any other basis. But the question that faces the AO is that the position being so strong as it appears to be, why did he not adopt the Expln. 3 to s. 43(1) when he sufficiently sees that after effecting the transfer there was a direct or indirect attempt to reduce the liability to income-tax. The purpose of the said Explanation is to cover all such contingencies and in that view wide powers are conferred on the AO. In the present case, in fact, he did it successfully obviating all collusive device in effecting the transaction though it cannot reasonably be said as the sole purpose of the transaction.

10. Placing reliance on the decision of the Supreme Court in Malabar Fisheries Co. vs. CIT (1979) 12 CTR (SC) 415 : (1979) 120 ITR 49 (SC) : TC 28R.572, it was argued on behalf of the assessee that there was no transfer of assets by the assessee (dissolved firm) to any person after the dissolution of the firm. That was a case where the Supreme Court was considering a question of law whether the distribution of assets of a firm consequent on the distribution amounts to a transfer of assets within the meaning of the expression ‘otherwise transferred’ occurring in s. 34(3) of the Act having regard to the definition of ‘transfer’ in s. 2(47) of the Act. At the outset, it may be pointed out that the Supreme Court in the above decision was not at all considering the impact of the provisions contained in Expln. 3 to s. 43(1) of the Act and the discussion therein was confined to the provisions contained in ss. 34(3) and 2(47). The Supreme Court in the course of the judgment said that upon the dissolution the firm ceases to exist; then follows the making up of assets, then discharge of debts and liabilities and thereupon distribution, division or allotment of assets takes place inter se between the erstwhile partners by way of mutual adjustment of rights between them. The distribution, division or allotment of assets to the erstwhile partners is not done by the dissolved firm. It was in this sense, the Supreme Court said that there was no transfer of assets by the assessee to any person. It further said that the distribution of assets did not take place eo instanti with the dissolution of the firm. There may be mutual adjustment of rights between the partners on dissolution of the firm. But that does not mean the AO is debarred from ascertaining the ‘actual cost’ of the assets in view of the provisions contained in Expln. 3 to s. 43 (1). The purpose to be served under this provision is totally different. The effectiveness of the provisions cannot be defeated in any manner, even if there is adjustment between the partners of the dissolved firm.

We cannot agree with the conclusion of the Tribunal that the revaluation of the assets on the eve of the dissolution of the firm was made bona fide for adjustment of the mutual rights of the firm. This is not a case where there is no written down value, which means, in the case of assets acquired in the previous year, the actual cost to the assessee and in the case of assets acquired before the previous year, the actual cost to the assessee less all depreciation actually allowed to him under the Act as defined under s. 43(6). Sec. 43(1) with Explanations thereof supersedes the general rule of law governing partnership, its assets and dissolution etc. The definition of ‘actual cost’ contained in s. 43(1) read with Explanations thereof affords a mechanism by which reduce the actual cost to a figure which is anything but real. When the asset was formally used by any other person for the purpose of his business and the main purpose of the transfer of the asset to the assessee is to claim a higher depreciation allowance so as to reduce the liability to pay income-tax, the ‘actual cost’ shall be determined by the AO in the exercise of the power conferred on him as prescribed in Expln. 3 to s. 43(1) no matter what the general law prescribes for determining the costs of the assets on dissolution of partnership firms and transfer of its assets.

Both the contesting parties, assessee as well as the Revenue, placed reliance on the decision of the Bombay High Court in Ginners & Pressers P. Ltd. vs. CIT 1978 CTR (Bom) 235 : (1978) 113 ITR 616 (Bom) : TC 29R.714, and the Tribunal said so in its impugned order. That was a case where s. 10(5)(a) of the 1922 Act corresponding to Expln. 3 to s. 43(1) of the present Act came up for discussion. The facts of that case narrated hereunder are more or loss similar to the facts on hand. The assessee, a private limited company, was a subsidiary of another private limited company. The object of formation of the assessee-company was to take over some oil and ginning mills, factories and land belonging to and used in its business by the present company. These assets were taken over by the assessee-company at a cost of Rs. 13,50,000. Their written down value for the parent company was only Rs. 2,21,412 while their original purchase cost to the parent company was Rs. 5,52,475. The assessee paid for the assets by issuing fully paid up shares of that value. The ITO applied the proviso to s. 10(5)(a) and, with the previous approval of the IAC, he fixed the actual cost of the assets to the assessee at their written down value in the books of the transferor plus the balancing charge arising under s. 10(2)(vii). The Tribunal rejected the contention of the assessee that the assets had been transferred to the assessee by the parent company after they had been got valued by valuers, because the material on the basis of which the value had been fixed by the valuers for the assets in question had been withheld by the witness who was examined on behalf of the valuers before the ITO and the non-production of such material led to an adverse inference being drawn against the assessee-company. On these facts, two questions arose for consideration before the High Court on reference. First question is whether the proviso to s. 10(5)(a) has been properly applied and the second question is, whether the Tribunal is justified in rejecting the valuation and drawing an adverse inference against the assessee. As far as the first question is concerned the Court found that the condition for attracting the proviso to s. 10(5)(a) was satisfied because the assets had been used by the parent company for their business before they were transferred to the assessee- company. On the second question the Court found that the Tribunal was justified in rejecting the valuation repo and drawing an adverse inference against the assessee. The first question alone is relevant in the present case and on that question the Court said that the ITO proceeded to fix or determine the actual cost (written down value) of the assets transferred by adopting the written down value of those assets transferred in the books of the transferor of the assessee-company as on the date of transfer and added to that figure the balancing charge arising under s. 10(2)(vii) of the Act. The Court further observed:”It cannot be disputed that this method, if adopted, would clearly give the actual cost of the assets transferred to the transferor-company as on the date of transfer, the determination would be irrational or unreasonable. If the ITO adopted this method of determining the actual cost of the transferred assets with the approval of the IAC, it will be difficult to say that the method adopted was unreasonable or irrational”. Even if the assessee produces the valuation report, it cannot be said that the above conclusion would be different. Therefore, the drawing of adverse inference against the assessee has no impact on the question decided by the Court. The attempt of the Tribunal to distinguish the above decision on the basis that the assessee has furnished the revaluation report in the present case would not fructify.

It is a settled position that the Court has power to disregard the corporate entity if it is used for tax evasion or to circumvent tax obligation. (See Firestone Tyre & Rubber Co. vs. Lewellin (1957) 1 WLR 464). In CIT vs. Sri Meenakshi Mills Ltd. (supra) the Supreme Court said that the IT authorities are entitled to pierce the veil of corporate entity and to look at the reality of the transaction. It further said : “It is true that from the juristic point of view the company is a legal personality entirely distinct from its members and the company is capable of enjoying rights and being subjected to duties which are not the same as those enjoyed or borne by its members. But in certain exceptional cases the Court is entitled to lift the veil of corporate entity and to pay regard to the economic realities behind the legal facade”.

In this premise it cannot be said that the AO has acted unreasonably or arbitrarily in adopting Expln. 3 to s. 43(1) of the Act and fixing the ‘actual cost’ accordingly.

12. As pointed out above, though large number of questions of law have been framed by the Tribunal for decision, we need answer only the questions referred to by this Court in the judgments referred to above. Once we answer these questions specifically, the answers to other questions would follow. On the common question referred to us in all these references, we answer that the assessee is not entitled to claim depreciation on the assets taken over from the partnership firm at the revalued figure. In other words, the question is answered in the negative, that is to say, in favour of the Revenue and against the assessee. On the additional question referred to us in IT Ref. Nos. 112 and 113 of 1996, we answer that Expln. 3 to s. 43(1) is attracted to the facts of the present case. That means the question is answered in the affirmative, that is to say, in favour of the Revenue and against the assessee. The reference cases are disposed of as above.

[Citation: 236 ITR 416]