P L D 1968 Karachi 561 (PLP)

6. In Ratilal B. Daftari v. Commissioner of Income‑tax, Bombay ((1959) 36 I T R 18) the dispute was in respect of a registered partnership consisting of 16 partners who were to share the profit or loss in proportion to the capital contributed by each partner, the share of the assessee, who was a partner and had contributed Rs. 25,000 out of the capital of the partnership of Rs. 3,45,000 was determined at Rs. 14,661 in accordance with the provisions of S. 23 (5) (a) of the Income‑tax Act. The assessee contended that the whole of the above amount did not belong to him but only two‑fifths viz. Rs. 5,864 and relied upon an agreement between himself and four others entered into on the same date on which the deed of the registered partnership was executed. The agreement provided that the five parties who had contributed diverse sums amounting to Rs. 25,000 were to share the profits or losses in proportion to their individual contribution and also mentioned that the terms and conditions mentioned in the registered partnership were to be applicable to and binding on them. On these facts the Bombay High Court held "that even in the case of the assessment of a partner of a registered firm what was to be considered was not the income allocated to his share by employing the machinery of section 23 (5) (a) but his real income ; and that real income was what remained after deducting the amounts which might be said to have been diverted and never constituted his real income and such amounts would have to be excluded to ascertain his real income ; for ultimately it was his real income which alone could be taxed and not any artificial or notional income that he maybe said to have earned ; and that, therefore, in this case only two‑fifths of the sum of Rs. 14,661 viz. Rs. 5,864 could be assessed in the hands of the assessee as his share in the profits of the registered firm and not the entire sum of Rs. 14,661".

7. In Bagyalaksh mi & Co. v. Commissioner of Income‑tax; Madras ((1961) 42 I T R 727) in a case of Hindu joint family at pages 735 and 736 the learned Judges of the Madras High Court considered the effect of a sub‑partnership on the income of a partner of a registered partnership and observed that a sub‑partnership entered into by one of several partners in the main firm would not, affect the registrability of either the firm or the sub‑partnership. To the same effect is the decision of the Supreme Court of India in Commissioner of Income‑tax v. Sivakasi Match Exporting Co. ((1964) 53 I T R 204). In that case there were five match factories in Sivakasi run by five different concerns of which four were firms and the fifth a sole proprietorship. In 1948 a person from each of these five concerns in his representative capacity formed a partnership, that partnership was refused registration under S. 26‑A of the Indian Income‑tax Act, 1922 on the ground that different firms could not constitute a valid partnership. Thereafter one partner from each of the four firms and the proprietor of the fifth concern in their individual capacity constituted the assessee firm and executed a deed of partnership on 1st April 1950, to carry on the business of banking and commission agent and of making the products of the match factories. The Income‑tax Officer refused registration of the assessee firm and on, appeal the Appellate Tribunal held that the partnership was not genuine for the following reasons :‑

(a) registration of the earlier partnership formed in 1948 had been refused ; (b) under clause 16 the assessee firm had the right to collect commission on the entire match production of the five concerns whether they effected their sales through it or not ; (c) capital was contributed to the assessee firm directly by J one of the four firms on behalf of its partner ; and (d) the other three firms divided amongst their partners the profits derived by their respective partners from the assessee firm. On a reference made the High Court held that the business was the business of the partners alone and not of the firms and that the circumstances relied upon by the Tribunal were irrelevant in ascertaining whether the partnership was real or not and the registration of the assessee firm under section 26‑A was wrongly refused. In this connection Subha Rao, J. observed as under at page 209: "It is not disputed that the partnership deed ex facie conforms to the requirements of the law of partnership as well as the Income‑tax Act. Under S. 4 of the Indian Partner ship Act, partnership is the relation between persons who have agreed to share the profits of the business carried on by all or any of them acting for all ; persons who have entered into the partnership with one another are called individually partners and collectively a firm and the name under which the business is carried on is called the firm name. The document certainly conforms to the said definition. There is also no prohibition under the partnership Act against a partner or partners of other firms combining together to form a separate partnership, to carry on a different business. The fact that such a partner or partners entered into a sub‑partnership with others in respect of their share does not detract from the validity of the partnership ; nor the manner in which the said partner deals with the share of his profits is of any relevance to the question of the validity of , the partnership. The document, therefore, embodies a valid partnership entered into in conformity with the law of partnership." The learned Judges further observed at page 210: "If the larger firms cannot constitute members of a new partnership, some of the partners of those firms can certainly' enter into a partnership shedding their representative capacity if they can legally do so. If they can do so, the mere fact that one of them borrowed the capital from a parent firm we are using this expression for convenience of reference or some of them surrendered their profits to, the parent first cannot make it any the less a "genuine first."

8. Mr. Dingomal, in the light of the above discussion, argued that the amount paid to the sub‑partners cannot be considered as the real income of the assessee and that as the Tribunal has held the sub‑partnership as a genuine transaction its registration could not be refused. In order to further strengthen his argument the learned counsel referred us to a decision of the Supreme Court of Pakistan in Commissioner of Income‑tax v. Amin Match Works (P L D 1964 S C 377). In that case certain minors were admitted to benefits of partnership. Constitution of the firm and its registration was refused on the ground that such a partnership was not permissible under the law. In this connection their Lordships observed as under: "It is no doubt correct that a minor cannot create a partnership but it cannot be said that by being merely admitted to the benefits of a partnership he also becomes a partner. In any event, we fail to appreciate why the inclusion of the minors should have rendered the constitution of the firm itself invalid when there were at least two adult partners, besides the minors, who could lawfully have entered into the partnership. Under S. 26‑A of the Income‑tax Act two conditions have only to be satisfied, firstly, that the firm has been constituted under an instrument of partnership, and, secondly, that the instrument has specified the shares of the partners. If these conditions are satisfied, the firm is entitled to registration. Both these conditions were fully satisfied in the present case." It was strongly contended before us that both the conditions laid down by their Lordships in the above‑mentioned case have been fulfilled by the sub‑partnership and therefore the learned Income‑tax Officer wrongly refused its registration.

9. On the other hand, Mr. S. A. Nusrat, the learned counsel for the Department, has contended that registration of firms under the Income‑tax Act is not a general or common law right, but it is a privilege given to the firms in order to get the benefit of the assessment ; and in such cases it is open to the Income‑tax Officer to examine whether the partnership is genuine, whether each of the partners mentioned therein is a real partner, whether the shares are 'specified properly, whether the shares specified are real ones and whether the profits which are to be distributed under the deed, will truly be the profits of those particular individuals. If he finds that there is no genuineness with regard to any one, it is open to him to reject the application on the ground that there was no genuine partnership brought into existence by the deed. In support of his contention the learned counsel placed reliance on the case of P. A. Raju Cheteiar & Brothers v. Commissioner of Income‑tax, Madras ((1947) 17 I T R 51). In our opinion this question is irrelevant for the decision of this case because the finding of the learned Income -tax Tribunal is that the sub‑partnership entered into between the father‑ and two sons in the present case is a genuine transaction. In this connection the learned Tribunal in he order of reference in para. 3 have clearly stated as under:

"At the time the appeals which give rise to these applica tions were heard the Tribunal found that no original deed of partnership setting up the firm of father and sons was produced at any stage. However, when these applications came up for hearing the Department came out with the original document which obviously necessitated the rectification of the mistake committed in paragraph 9 of the Tribunal's appellate order, and, therefore, we have, by our order under section 35 of the Income‑tax Act, deleted the aforesaid para graph 9: ' Thus it is quite clear that the finding of the Tribunal that it was not a genuine sub‑partnership was rectified and it has been held that the sub‑partnership is a genuine transaction. It is, therefore, unnecessary for us in this case to consider the question of the genuineness of the sub‑partnership.

10. Mr. Nusrat then referred to a decision of the Calcutta High Court in Mahaliram Santhalia v. Commissioner of Income‑tax (Central) Calcutta ((1958) 33 I T R 261) and contended that after a proportionate share of the income of a pander of the firm bad been included in the total income of a partner for the purposes of his personal assessment it could not be further divided between such partner and his sub‑partners. In support of his contention the learned counsel referred us to section 23 (5) (a) of the Income‑tax Act. He further contended that a partner in a firm who has already earned and received his share of profits cannot by a voluntary act in respect of such sum by mere diversion to strangers escape liability in respect of such income. Both the contentions of the learned counsel were at length discussed in the above‑mentioned Calcutta case. In that case the four partners including one M of a firm A, each owning a one fourth share in the firm, made an application for registration of the firm under S. 26‑A of the Income‑tax Act on the basis of a partnership deed dated 24th December 1943. The Income‑tax Officer allowed the application and assessed the firm as a registered firm for four assessment years. In respect of none of these years did M include his share of the income from the firm A on the ground that he was a partner of the firm A not in his individual capacity, but as a representative of another firm B of which bin was a partner with three others, and that the proportionate share of the income in firm A attributable to his share was the income of firm B. In support of his case M produced an agreement dated 3rd April 1944, between the partners of firm 7 which contained a provision to the effect that income from firm A belonged to all the partners of firm B. Firm B did not include M's share of the income in firm A in its own total income. On these facts it was held by the Calcutta High Court that as each of the partners of the firm A, including M, made application under section 26‑A for registration of the firm in his personal capacity on the footing that he was a partner .as an individual and that was the basis upon which the registration was allowed, the consequence of allowing registration on the representation thus made was that laid down, in S. 23 (5) (a) of the Act i.e. 1/4th share of the income of the firm was bound to be included in the total income of each partner in his personal assessment, and it was impossible for a partner's share of the income to be further divided between such partner and other parties. It was further held that apart from the fact that neither the deed of partnership of firm A nor the application for registration gave the slightest indication that firm B had any interest in firm A, firm B, being itself a partnership, could not itself be legally a partner of firm A. The learned Judges further observed that under the second proviso to section 30 (1) M was entitled to raise the question of apportionment of his share of the income in firm A only in an appeal from the assessment of that firm, but was not entitled to raise that question in the proceedings for assessment of his own total income, as his share in the income of a firm A was a matter determined by an order passed in the assessment of firm A. In this connection the learned Judges further observed as under :‑

"In the second place, it is quite impossible to see how there could conceivably be any question of diversion by an overriding title in the present case, which could be said to prevent the share of Income received by Mahaliram Santhalia from, the Benares‑ Steel Rolling Mills from becoming his income. If, as Mr. Mitra conceded, Mahaliram was rightly taken as a partner of the Benares Steel Rolling Mills m his personal capacity and if a one‑fourth share of the income was rightly allocated to him, any agreement between him and his three partners of the firm of Radhakissen Santhalia, under which the income was to be treated as the income of the whole firm, could only be an agreement by which Mahaliram Santhalia was allowing what was really his income to be treated as the income of the firm or, in other words, an agreement by which he was applying or distributing an income which he had already himself earned and received. Such application or distribution would be voluntary act of Mahaliranp Santhalia in respect of a sum which, it was conceded, had rightly been included in his own total income sad, therefore, was his own income. If the moment the share of income from the Benares Steel Rolling Mills was allocated to Mahaliram Santhalia, it became his income and liable as such to be included in his own total income for the purpose of his personal assessment, an agreement by him with other persons regarding the right to that income could only be a voluntary disposition of his income by him. No question of diversion by superior title could possibly arise."

10. Mr. Nusrat further referred us td a decision of the Privy Council in Pondicherry Railway Co. Ltd. v. Commissioner of Income‑tax, Madras (1931 P C 165) and particularly referred us to the following observations at page 170 of the report: "A payment out of profits and conditional on profits being earned cannot accurately be described as a payment made to earn profits. It assumes that profits have first come into existence. But profits on their coming into existence attract tax at that point and the revenue is not concerned with the subsequent application of the profits. It was persuasively argued that inasmuch as the Pondicherry Company as a condition of making any profits must pay over one half of them to the French authorities and could never itself receive the whole profits the payment so made was pf the nature of a rent payable by the Company or a charge on the undertak ing. But the analogy in their lordships' opinion is imperfect, and the form in which the parties have contracted that the French Government can participate in the success of the undertaking precludes the deduction claimed."

11. These are the two divergent views placed before us by the learned counsel for the parties in support of their respective contentions. After carefully considering their arguments, we have come to the conclusion that the Tribunal has fallen into an error in deciding both the questions referred to this Court against the assessees. In the first place, the Tribunal failed to notice that in law there is no bar for a partner to agree to share the profits derived by him with a stranger. This principle of law is enunciated by Lindley in his treatise on Lindley's Law of Partnership at page 67, 11 th Edition. It was also approved by the Privy Council in A I R 1932 P C

63. This being the legal position the sub‑partnership agreement entered into by Mr. Merwan K. Irani with his two sons was a perfectly valid transaction and it could only be discarded on the ground that it was not a genuine transaction. The finding of the Tribunal in this respect is that it is a genuine transaction. Keeping in view in such circumstances, the decision of our own Supreme Court referred to above it is difficult for us to hold that the Tribunal was justified in refusing the registration of the sub‑partnership. According to their Lordships' observations at page 377, section 26‑A of the Income‑tax Act is only to be satisfied in two respects. Firstly, that the firm has been constituted under an instrument of partnership and, secondly, that the instrument specifies the shares of the partners. If these two conditions are fulfilled the firm is entitled to registration. In the present case it cannot be disputed that both these conditions have been fulfilled. It is not disputed that Mr. Merwan K. Irani is an old person and his two sons are attending to the two partnership business on his behalf and if for this purpose he has parted with his 8 annas share in the above firms in favour of his two sons, it is a perfectly proper and valid arrangement. We are, therefore, of the view that the Tribunal was not justified in setting aside the registration of the sub‑partnership directed by the Appellate Assistant Commissioner.

12. Secondly, Mr. Nusrat's contention that diversion of profits received by a partner is not permissible in law in view of the provisions of section 23(5)(a) of the Income‑tax Act has not impressed us. In law it is the total and real income of the partner which is subject to assessment. The learned counsel has not drawn our attention to any provision of law showing that the income of a partner in the partnership firm allocated to his share has to be assessed separately from his other income. This provision of law only lays down that such income could be assessed as an individual income and that it will be added to his other income. Otherwise in. order to assess his total income it is open to him to plead that his real income should be taken into consideration; and to achieve that conclusion any amount paid by bite to bit sub‑partners shall We to be deducted and then his real income would be determined after such deduction. In a different context the Privy Council approved this principle in Bejoy Singh Dudhuria v. Commissioner of Income‑tax, Calcutta (A I R 1933 P C 145). Their Lordships observed at page 147: "When the act by S. 3 subjects to charge "all income" of an individual, it is what reaches the individual as income which it is intended to charge." Their Lordships later on at page, 148 observed: "While their Lordships are disinclined to entertain any argument from the one system to the other, they would infer if any inference were permissible, that the omission from the Indian Act of any such provision points rather to an intention to tax, in Lord Davey's phrase, only "the real income" of the tax‑payer, than to an intention to impose, without right of re‑imbursement, a tax on what is charged upon his income."

13. We have, therefore, found much force in the argument of Mr. Dingomal that in the case of a partner in a registered firm when the question arises as to his individual assessment it is not the income allocated to his share under section 23(5)(a) that has to be taken into consideration but his real income. Otherwise if this principle is not followed what would be assessed would not be his real income but an artificial income said to be earned by him. There can in law be no manner of doubt that his real income would be what remains after deducting the amount diverted which never constitute his income and both in law and equity it shall have to be excluded in order to determine his real income.

14. With respect we are unable to share the view of Chakravartti, C. J. expressed in Mahaliram Santhalia v. Commissioner of Income‑tax, Calcutta referred to above. We have already held that no such bar the impossibility of which has been referred to in the above decision‑exists under section 23(5)(a) of the Income‑tax Act. Nor is there any such difficulty as has been pointed out by the learned Judge under section 30(l) of the Income‑tax Act. Under proviso two of this provision of law the assessee has been granted a concession that in such cases he need not file any appeal against the assessment of his total income. Moreover it only shows that though an individual partner may appeal against the assessment of the firm, he cannot in an appeal from an order assessing him personally ask for re‑determination of the question of the assessment of the firm.

15. The upshot of the above discussion is that there being a valid and genuine agreement between the partners of Messrs Merwan & Sons and one of them being a partner in the principal firms referred to above, this arrangement is nothing short than in the nature of an overriding agreement which had the effect of diverting at source the share of profits earned from them which had been allocated to the share of Mr. M. K. Irani. In law there being a valid sub‑partnership his real income would he calculated after separating the share of the two sons under its terms. In that view of the matter the tribunal erred in refusing the registration of the sub‑partnership and further had fallen into an error in treating his share of profits in the two principal firms as his real income.

16. We would, therefore, answer the two questions referred to this Court in the following manner: '

1. In the negative.

2. In the negative. The reference is accordingly answered. The Department will bear the costs of this reference. S. Q. Reference answered in tote negative.