1969 PLP 622 (PTD)

SHAMEEM HUSSAIN KADRI, J.‑This is a reference made by the Income‑tax Appellate Tribunal, Karachi, under section 66(1) of the Income‑tax Act, at the instance of the Commissioner of Income‑tax, Karachi.

2. The facts of the case are that on the 2nd of June 1961, a firm consisting of five partners decided to convert the same into a private limited company. The firm was carrying on the manufacture and sale of condensed milk ice cream etc. On the eve of the transfer of the assets of the firm to the private company, all the assets and liabilities of the firm are taken over by the company at its book value. The fixed assets were transferred at their original cost of Rs. 4,20,801 while the written down value of the assets was estimated at Rs. 2,13,

587. The difference between the original cost and the written down value i.e. a sum of Rs. 2,07,214 was treated by the Income‑tax Officer as profits and tax was levied on this profit under the second proviso of section 10(2)(vii) of the Income‑tax Act,

3. An appeal was filed by the assessee before the Tribunal claiming that the transfer of the fixed assets was not within the mischief of section 10(2)(vii) of the Income‑tax Act as the shares allotted by the limited company to its shareholders were equivalent to the shares of the partners of the previous firm. In these circumstances, there was no sale which could result in any profit.

4. The Tribunal on the 13th of November 1963 accepted the appeal and decided that the difference between the original cost and the written down value of the assets was not profits and, as such, it could not be assessed to tax by the Income‑tax Officer.

5. On the application of the Commissioner of Income‑tax Karachi, the Tribunal made a reference to this Court for the determination of the following question :‑ "Whether on the facts and in the circumstances of the case the Tribunal was justified in holding that the transaction of transfer of fixed assets was not a sale, so as to attract the provisions of section 10(2)(vii) of the Income‑tax Act?"

6. Mr. Nusrat learned counsel appearing on behalf of the Department submitted that a company is a different entity from that of a partnership, and the transfer of the assets to the company by the shareholders of the firm obviously amounts to a sale and, therefore, the difference between the original cost and the written down value is taxable under section 10(2)(vii) of the Income‑tax Act. In support of his submission he cited Maharajadhiraj Sir Kameshwar Singh v. Commissioner of Income‑tax, Bihar and Orissa ((1963) 48 I T R 483), a decision of Patna High Court. Learned Judges observed that‑ "the doctrine that no man can make a profit out of himself is not applicable to transactions between a person and a limited company, even though all the shares in the company are owned by that person, because from a legal point of view a company is an entity entirely distinct from its shareholders." The facts of the above referred case were that the assessee who was carrying on the publication of some newspapers floated a private limited company for the purpose of carrying on this business and sold to the company the said business as a going concern for the sum of Rs. 12,50,000 which was received by the assessee in the shape of Rs. 12,500 fully paid up shares of Rs. 100 each in the company. Out of the 25,000 shares in the company only 50 shares were held by the nominees of the assessee, the rest of the shares were all held by the assessee himself. The original cost of the building, plant and machinery which were transferred was Rs. 2,79,822 and the written down value at the time of transfer was Rs. 1,49,

037. The Income‑tax authorities treated the excess, namely, Rs. 1,30,785 as profits under the second proviso to section 10(2)(vii) of the Income‑tax Act and assessed this amount to income‑tax. It was submitted on behalf of the assessee that for purposes of levying tax, it was the duty of the authorities and Courts to lift the veil of corporate entity and pay regard to the economic realities behind the transaction and, since, in substance, all the shares in the company were owned by the assessee, there was really no sale to a different party but only a different method of carrying on the same business and that the excess of Rs. 1,30,785 could not be assessed under the second proviso to section 10(2)(vii). It was held in this case‑ "that a person veiled by the mask of corporate personality cannot be allowed to pierce the veil himself for his own benefit. The assessee, though he was the owner of all the shares in the company, cannot claim to be treated as if he was identical with the company in order, to promote his own benefit or advantage. The assessee and the company were distinct legal entities and the sum in question was rightly assessed to income‑tax."

7. He then cited a decision of the Dacca High Court reported as Commissioner of Income‑tax, East Pakistan, Dacca v. A. K. Khan Plywood Co., Chittagong ((1966) 13 Taxation 271). In this case the partners of a firm who were carrying on the business of manufacture and sale of plywood tea and tea‑chest, etc. formed themselves into a private limited company, the shares allotted to each of them in the company being in the same proportion as the shares held by them in the firm. The assets of the firm having the written down value of Rs. 2,13,349 were transferred to the original cost of Rs. 5,89,

319. The question for decision before the High Court was whether the transaction was "sale" within the meaning of the second proviso to section 10(2)(vii) of the Income‑tax Act and the difference between the written down value and the original cost was liable to tax. A. S. Chowdhury and K. M. Hassan, JJ. held.‑ "(i) if a firm sells its assets to another company the vendor is liable to pay income‑tax for the difference between the written down value on the date of the sale and the price at which the assets are actually sold, that is, the profits earned by it, even if the partners of the firm are identical ; and (ii) there is no exception in the second proviso in clause (vii) of section 10()) to the effect that if the property remains in the same hands, it will not be a sale within the meaning of this section. If there is a sale in the eye of law and if a profit results therefrom, the making of such profits is liable to taxation."

8. In favour of the assessee respondent a number of cases were cited at the bar. In William Richard Doughty v. Commis sioner of Taxes (AIR 1927 P C 76), a similar proposition was examined. It was held that :‑‑ "Income‑tax being a tax upon income, the sale of the whole concern which can be shown to be a sale at the profit as compared with the price given for the business, or at which it stands in the books, does not give rise to a profit taxable to income‑tax." Their Lordships also observed in this case‑ "It is easy enough to follow out this doctrine where the business is one wholly or largely of production, e.g., dairy farming business or a sheep‑rearing business, but where a business consists entirely in buying and selling goods it is more difficult to distinguish between an ordinary and a realization sale, the object in either case being to dispose of goods at a higher price than that given for them, and thus to make a profit out of the business. In such a case, a profit made by the sale of the whole of the stock, if it stood by itself, might well be assessable to income‑tax. But the case is different where the sale is only a slump transaction as earlier held by Stout, C. J. in J. & M. Craig (Kilmarnock) Ltd. v. Inland Revenue ((1914) S C 318 (Appl.)).

9. In Commissioner of Income‑tax, Bombay City v. Sir Homi Mehta's Executors ((1955) 28 I T R 928), the assessee and his sons formed a private limited company and transferred to that company shares in several joint stock companies which the assessee had held jointly with his sons, for Rs. 40,97,00 which was the market value of the shares at that time. It was found that these shares had cost to the assessee only Rs. 30,45,017 and the Income‑tax authorities levied income‑tax on the difference between the market price and the cost price of the shares on the ground that the assessee had made a profit to that extent by this transaction. Chagla, C. J. and Tendolkar, J. held that‑ "though the assessee and his sons on the one hand and the private limited company formed by them were distinct entities in law, the real result of the formation of the company and the transfer of the shares to that company was only that instead of the shares being jointly held as individuals they were held by these very persons as a limited company ; the so‑called sale of the shares to the company was not a business activity entered into with the object of earning a profit, and was not really a sale but merely a procedure adopted for readjustment of their position as holders of the shares ; the assessee did not make any profit or gain in a commercial sense by transferring the shares to the company ; and the Income‑tax authorities were not entitled to levy income‑tax on the difference between the market price and cost price of the shares merely because the market price of the shares at the time of transfer was higher than the cost price." Their Lordships also considered in this case their earlier decision in Sir Kikabhad Premchand v. Commissioner of Income‑tax ((1953) 24 I T R 506), a decision of the Bombay High Court which was reversed by the Supreme Court of India. The facts of that case were that Sir Kikabhai Premchand who was a dealer in silver and shares, withdrew certain amount of silver and shares from the stock‑in‑trade and made a trust in favour of himself, his wife and children. The learned Judges of the Bombay High Court held that the silver and shares ought to be valued at the market price at the date of the withdrawal and if the market price was higher than the cost price the assessee was liable to pay tax on it. The Supreme Court of India did not accept this view and decided that Sir Kikabhai was not liable to tax. It was observed by the Supreme Court at page 509 as under :‑ "We are of opinion that the appellant was right in entering the cost value of the silver and shares at the date of the withdrawal, because it was not a business transaction and by that act the business made no profit or gain, nor did it sustain a loss, and the appellant derived no income from it. He may have stored up a future advantage for himself but as the transactions were not business ones and as he derived no immediate pecuniary gain the State cannot tax them, for under Income‑tax Act the State has no power to tax a potential future advantage. All it can tax is income, profits and gains made in the relevant accounting year." Their Lordships also considered the Privy Council case referred to above Willian Richard Doughty v. Commissioner of Taxes. The opinion expressed by the learned Judges was that Sir Homi Mehta did not make any profit or gain and, therefore, the mere fact that the shares which he transferred had a market value at the date of the transfer higher than the cost price of the shares did not make him liable to pay tax on that difference.

10. Another reported case Rogers & Co. v. Commissioner of Income‑tax, Bombay City-II ((1958) 34 I T R 336), was cited at the bar. In this case a firm was carrying on the business of making aerated waters. The firm converted itself into a private limited company. The partners of the firm were allotted the shares in the company in the same proportion as the shares they held m the firm, except as to a slight difference owing .to the shares being rounded off to a specific number. The assets of the firm having the written down value of Rs. 3,81,848 were transferred to company at the original cost of Rs. 4,85,

354. The question was whether the difference between the original cost and the written down value was liable to income‑tax under the second proviso to section 10(2)(vii) of the Income‑tax Act. Their Lordships of the Bombay High Court held that‑ "the transfer of the assets of the firm to the company was substantially and really merely a readjustment made by the members to enable them to carry on their business as a company rather than as a firm, and no profits in the commercial sense was made thereby; the transfer of the assets of the firm to the company was, therefore, not a sale and the provisions of the second proviso to section 10(2)(vii) did not apply. In all transactions which come up for consideration in a taxing statute the Court has to look not at the legal form which the transaction has but to the real nature of the transaction. The basic idea underlying the second proviso to section 10(2)(vii) is that the vendor has made profit by the transfer of his assets." Their Lordships followed the earlier case of Bombay High Court and decided that the transaction effected between the firm "Rogers & Company" and the "private limited company" was not a sale.

11. Calcutta High Court also considered this question in the case Commissioner of Income‑tax (Central), Calcutta v. Mugneeram Bangur & Company ((1963) 47 I T R 565). The facts of that case were that a firm consisting of five partners, which was doing business of land development, decided to float a limited company to carry on the business and transferred the whole business of the firm including all its stock in trade consisting of land and goodwill to the company for the sum of Rs. 34,99,

300. The capital of the new company consisted of 34,993 shares of Rs. 100 each, of which all but seven shares were allotted to the five partners and the consideration for the transfer was the allotment of these 34,993 shares. Assets transferred included goodwill of the firm valued at Rs. 2,50,

000. The Income‑tax authorities levied tax on this amount, holding that the firm had no goodwill and that this amount really represented the increase in value of the land and was, therefore, a profit made by the firm by the transfer G. K. Mitter and Ray, JJ. held that:‑ "On the facts and circumstances of the case and in view of the finding of the Tribunal that the entire share capital of the company (excepting seven ordinary shares) was taken over by the partners of the firm in lieu of the sale price of the business as a whole, there could be no profit in the transaction by which the entire stock‑in‑trade and the business of the firm was transferred to the limited liability company. The fact that two outsiders were brought in as directors with seven shares allotted to them out of 39,300 shares made no difference. Nor was there any difference in principle between tire case of conversion of business into a private limited company and one in which it is converted into a public. limited company if in the latter company outsiders are not allotted any sizeable proportion of the shares issued. With regard to the goodwill, since there cannot be a sale by a person himself for income‑tax purposes there could equally be no transfer of goodwill by a person to himself. Further, as the members of the firms were not giving up the right to carry on business in land develop ment, the transfer of goodwill by them in the absence of an undertaking not to compete meant nothing. Even if the value of the stock‑in‑trade taken over by the company was greater than the figure shown therefore in the agreement for sale, in the circumstances of the case there was no profit which could be taxed." In this case, earlier cases cited by us, namely, William Richard Doughty v. Commissioner of Income‑tax Sir Kikabhai Premchand v. Commissioner of Income‑tax, Commissioner of Income‑tax., Bombay City v. Sir Home Mehta's Executors and Rogers & Company v. Commissioner of Income‑tax, Bombay City‑II, were considered. A number of English and Indian authorities were also considered in this judgment. The conclusion arrived at by the learned Judges was that :‑ "If there cannot be a sale by a person to himself for income‑tax purposes there could equally be no transfer of goodwill by a person to himself. Secondly, as already pointed out, the members of the firm were not giving up the right to carry on business in land development and therefore, the transfer of goodwill by them in the absence of an undertaking not to compete meant nothing. As the assets of the firm transferred to the company have been itemised and as there can be no question of variation of the figures given in items Nos. 3 to 8 in the agreement for sale, it must be held that Rs. 2,50,000 shown as the value of the goodwill must be represented by surplus on the sale of lands which was the stock‑in‑trade of the assessee‑company. So far as question No. 3 is concerned, even if the value of the stock‑in‑trade taken over by the company was greater than the figure shown therefore in the agreement for sale, in view of the answer to question No. 4, there was no profit which could be taxed." Another case Commissioner of Income‑tax, Kerala v. Morning Star Bus Service ((1963) 49 I T R 927), was placed before us. In this case an association consisting of five persons who were carrying on transport business formed themselves into a private limited company and the assets of the association including seven buses were transferred to the company. The written down value of the buses in the books of the association was Rs. 24,302 and their value was shown in the books of the company as Rs. 70,

000. The Income‑tax authorities, applying the second proviso to section 10(2)(vii) of the Income‑tax Act, 1922, assessed the difference between Rs. 70,000 and Rs. 24,302, namely, Rs. 45,698, as profits of the association of the year in which the transfer took place. The Tribunal reserved this order. It was held by M. S. Menon, C. J. and P. Govindan Nair, J. that :‑ "though the association and the private limited company were different legal entities and in a strict legal sense of the term there was a `sale' of the buses by the association to the private limited company, yet, since the persons who owned the buses before and after the transfer were identically the same persons, in substance and in a commercial sense there was no sale but only a readjustment for the purpose of carrying on the business in another form, and the sum of Rs. 45,698 was not, therefore, assessable as profits of the association under the second proviso to section 10(2)(vii) of the Income‑tax Act, 1922."

12. Learned Judges of the Patna High Court in case Maharajadhiraj Sir Kameshwar Singh v. Commissioner of Income tax, Bihar and Orissa, referred to above, while coming to a contrary decision did not take into consideration the two Bombay cases (1) Commissioner of Income‑tax, Bombay City v. Sir Homi Mehta and (2) Rogers & Co. v. Commissioner of Income‑tax, Bombay City‑II. In the circumstances of this case the learned Judges held that they were unable to lift the veil of corporate entity and look behind the transaction of sale in order to see who were the real parties to this transaction. The company being a. separate entity, and even if the subscribers of the new company were the same persons they could not be so treated. With utmost respect we do not agree with the principle laid down by the learned Judges. In the first place, because it is a well‑established commercial principle of law that nobody can sell to himself and make profit out of such a sale. Although it is true that company is entirely a separate body in the eye of law having its own assets and liabilities other than those of the individuals who are the subscribers of the company yet in principle the holders of the shares in the company are the same and their shares were to the same extent to which they were the shareholders in the firm, they cannot themselves be considered to be buyers and sellers of their rights muchless they could be dubbed to have made profit out of the so‑called sale.

13. In the Dacca case cited above, the learned Judges did not take into consideration the Calcutta case, Commissioner of Income‑tax (Central) Calcutta v. Mugneeram Bangur & Company ((1963) 47 I T R 565), which is the unanimous view of the Indian High Courts except the view taken in Patna case (1963) 48 I T R

483. We have already held that the Judges of the Patna High Court did not consider the two Bombay cases cited earlier.

14. With utmost respect to the contrary view expressed by the Patna High Court and the Dacca High Court, we are not impressed by the reasoning of the learned Judges in these decisions. The majority view is that if the partners of a firm decide to float a company transferring their assets in the firm to the new company, such a transfer is not a sale. The contrary view would be a clog in changing the business of firms to corporate bodies, and they would be hampered from converting themselves into limited companies and perhaps this may lead to some undesirable devices which the promotors of the new company may have to adopt for that purpose. We need not repeat the well‑known principle followed by the majority Courts that no person can himself be a buyer and seller and commercial it is not possible that such a sale, if at all, by any stretch of imagination, could be considered as one would result into an profit, and unless profit is made, such a transfer would not come within the mischief of section 10(2)(vii) of the Income‑tax Act. Legally no doubt, it is true that a company is a separate entity from the subscribers of the company but logically and commercially it makes no sense at all that when partners in a firm decide to float a new company with almost the same shares in the new company to the extent of their shares in the firm they would be buyers and sellers of their own interest. The assets and liabilities of the firm are transferred to the company, but as shareholders of the company their liabilities though limited but it is limited to the extent of their shares in the old firm: In view of the matter, we fail to understand how this act of persons who being transferors of their shares in a firm to the new company which allots them shares to the extent of their interest in the firm can be termed as a "sale", which can result in any profit.

15. As a result of the foreign discussion, we are of the view that the Tribunal was justified in holding that the transaction of transfer of the assets by the firm in question was not a sale so as to attract the provision of second proviso to section 10(2)(vii) of the Income‑tax Act. The reference is answered in the affirmative. In view of the complicated question of law involved we do not propose to make any order as to costs. Reference answered in affirmative.