P L D 1969 Karachi 261 (PLP)

ANWARUL HAQ, J. ‑The following question has been referred to us under section 66(1) of the Income‑tax Act by the Income‑tax Appellate Tribunal, Karachi, at the instance: of the Commissioner of Income‑tax :‑ "Whether on the facts and in the circumstances of the case the sums expended on the defence of the employees who were challaned under section 3 of Hoarding and Black Marketing Order, 1956 because of the vicarious liability laid down in section 3 of that Order was an expenditure laid out or expended wholly and exclusively for the purposes of the business and allowable as a deduction under section 10 (Z) (xvi) ?"

2. The question has arisen in the following circumstances. The assessee, namely, Messrs Dalmia Cement Company Limited, Karachi, is a public limited company and claimed allowance of expenses incurred by it on defending its Manager and Sales Manager who were prosecuted on the charge of selling cement in the black market to three parties under section 3 of the Essential Commodities (Control of Distribution) Order, 1956. The amounts involved are Rs. 5,000 for the assessment year 1959‑60, Rs. 11,925 for the year 1960‑61 and Rs. 5,000 for the year 1961‑

62. The case was commenced against the employees in April 1957 and ended in their acquittal on the 7th of May 1960. The Income‑tax Officer held the expenditure to be inadmissible as, according to him, it could not be regarded as having been incurred wholly and exclusively for the purpose of the business. In appeal it was contented before the Tribunal that the charges levelled against the employees related to the performance of duties in the course of their employment and it was to preserve the business that this expenditure was incurred in order that the company may retain its good name and the goodwill of its employees, which were necessary for the carrying on of its business. After reviewing the cases cited at the Bar the Tribunal came to the conclusion that it was not the company but the Manager and the Sales Manager who were faced with the possibility of conviction and imposition of the prescribed penalty, and therefore, the expenses that the company 1ncurred on the defence of these two employees were not for the purpose of saving itself from possible conviction, but for maintaining its good name and retaining the good will of the employees without which the business could not be successfully carried on. It concluded by saying that "it was thus wholly and exclusively for the purpose of business that this expenditure was laid out and we have no hesitation in holding that all the amounts in the three years should be admitted to deduction".

3. It is contended on behalf of the Income‑tax Department that the commission of an act in contravention of any law by an employee of the assessee cannot be deemed to have been done or executed for purposes of business, and the Tribunal was, therefore, not justified in holding that the expenditure incurred on defending the employees was allowable under section 10(2)(xvi). It is submitted that in every criminal prosecution the primary object of defence must be to save the accused from conviction and the imposition of penalty whether by way of fine or imprison ment, and accordingly the legal expenses incurred in that behalf could not be regarded as being wholly and exclusively for the purpose of the business in question. The stand taken on behalf of the assessee, on the other hand, is that in the present case the assessee being a public limited company was not faced with prosecution and possible conviction, but was called upon to defend its employees who had been prosecuted for acts done in the normal course of the business of the assessee, in view of the vicarious liability created by the relevant provision of the Hoarding and Black Marketing Order, 1956. It is argued that in these circumstances the legal expenses were wholly and exclusively for the purpose of the business of the assessee.

4. Subsection (1) of section 10 of the Income‑tax Act, 1922 lays down that "subject to the provisions of this Act, the tax shall be payable by an assessee under the head Profits and Gains of business, profession or vocation in respect of the profits or gains of any business, profession or vocation carried on by him". Subsection (2) of the. same section then contemplates that "subject to the provisions of this Act, such profits or gains shall be computed after making the following allowances" and there follows a list of 18 items. We are concerned with item No. (xvi) which reads as under "Any expenditure, not being in the nature of capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purpose of such business, profession or vocation."

5. It will be seen that the test to be applied is whether the expenditure was laid out or expended wholly and exclusively for the purpose of the business, profession or vocation. If so, the expenditure would be allowable, but not otherwise. While considering a similar question with regard to item No. (xv) of section 10(2) of the Indian Income‑tax Act, which is in identical terms as item (xvi) of the Pakistan Act, a Division Bench of the Bombay High Court held in J. B. Advani & Co. Ltd. v. Commissioner of Income‑tax and E. P. Tax (A I R 1950 Born. 297) that "in determining whether the expenses incurred by the assessee in defending a criminal prosecution are a permissible deduction under section 10(2) (xv) a distinction has to be made between cases where the criminal prosecution ends in conviction and where it ends in acquittal. In the former case the assessee who is guilty of a breach of the law cannot be heard to say that the costs of litigation against him were a permissible deduction because the commission of the offence was not necessary for the purpose of its trade. But in the latter case two tests have to be applied before the assessee can be allowed the deduction. The first test would be whether the assessee was charged with regard to a transaction which took place in the ordinary course of business and the other test would be whether he was charged in his capacity as a trader. If these two tests are satisfied and the Court comes to the conclusion that the primary object of incurring the expenditure was to protect the good name of the‑ business, then it could be said that the expenditure was wholly and exclusively for the purposes of business." Applying these tests to the case before them the learned Judges held that the assessee, a trading company, was entitled to claim deduction in respect of expenses incurred by it in defending a criminal prosecution against its directors and salesman in respect of charges which were incidental to the business and which ended in their discharge, as the primary and paramount object of the company was to save the reputation of the company as trading company so that its business should not be affected.

6. This decision of the Bombay High Court came up for consideration before the Indian Supreme Court in The Commissioner of Income‑tax, West Bengal v. H. Hirjee (A I R 1953 S C 324) and the correctness of the distinction drawn by the High Court between the legal expenses of a successful and unsuccessful defence was doubted, and it was observed that "the deductability of such expenses under section 10(2)(xv) must depend on the nature and purpose of the legal proceeding in relation to the business whose profits are under computation, and cannot be affected by the final outcome of that proceeding. Income‑tax assessments have to be made for every year and cannot be held up until the final result of a legal proceeding, which may pass through several Courts, is announced". 1he learned Judges further observed that in the case of a criminal prosecution defence cannot easily be dissociated from the purpose of saving the accused person from a possible conviction and imposition of the prescribed penalty, whereas no such question could arise in the matter of legal expenses incurred in a civil action connected with the affairs of the assessee. On this view of the matter, the learned Judges disallowed the expenses incurred .by the assessee in defending himself against a criminal prosecution.

7. The learned counsel for the Income‑tax Department placed strong reliance on this decision of the Indian Supreme Court, and also drew support from another judgment of the same Court cited as Messrs Haji Aziz, etc. v. The Commissioner of Income‑tax, Bombay City‑II(A I R 1961 S C 663) as well as from Messrs Yasin (East Pakistan Limited), Chittagong v. The Commissioner of Income‑tax, East Pakistan (P L D 1968 Dacca 583). In the first mentioned case it was held that "infraction of the law is not a normal incidence of business and, therefore, only such disbursements can be deducted as are really incidental to the business itself. No expense which is paid by way of penalty for a breach of the law can be said to be an amount wholly and exclusively laid for the purpose of the business even though it may involve no personal liability in the sense of a fine imposed for an offence committed. Anything done which is an infraction of the law and is visited with a penalty cannot on grounds of public policy be said to be a commercial expense for the purpose of a business or a disbursement made for the purposes of earning the profits of such business". This view of the Indian Supreme Court was followed in the Dacca case.

8. It seems to us that the two cases just mentioned are not directly relevant in the present context, for we are not dealing with the allowability of a sum paid as a penalty for an infraction of the law, but with legal expenses incurred in defending a criminal prosecution. There is a clear distinction between these two items. While the position does not admit of any doubt with regard to a sum paid as a penalty, the deductability of legal expenses must always depend upon the facts and circumstances of each case.

9. There is another case from the Indian jurisdiction which is more to the point, namely, J. N. Singh & Co. (Private) Ltd. v. Commissioner of Income‑tax, New Delhi ((1966) 60 1 T R 732). In that case it was held that "expenses incurred in defending an employee against a criminal prosecution with regard to a transaction carried out in the ordinary course of business of the assessee can be allowed as a permissible deduction. In the case of an employee, such an expenditure is incurred to protect the good name of the business, the prosecution having emanated with regard to an act which took place in the ordinary course of business and the expenditure would be wholly and exclusively for the purpose of the business". In coming to this conclusion the learned Judges took due note of the decision of the Supreme Court of India in Hirjee's case and stated that the facts of that case were distinguishable on the ground that the assessee, namely, Hirjee, was defending himself from prosecution, whereas in the case before them the assessee was defending its employee and, therefore, its primary purpose was to protect the good name of the business and not itself from the consequences of the prosecution. On the same ground the learned Judges also distinguished the Rangoon case cited as The Commissioner of Income‑tax v. Gasper & Co. ((1940) I T R 100).

10. The position which emerges from the foregoing discussion is that in order to claim an allowance under item (xvi) of subsection (2) of section 10 of the Act in respect of legal expenses incurred on a criminal prosecution, it must be shown that the prosecution arose out of acts performed in the ordinary course of business of the assessee A and that the primary purpose of the expenditure was not to save the assessee himself from the consequences of the prosecution but to safeguard the good name of the business and to protect and preserve the goodwill of the employees of the assessee, without which no business could be carried on successfully. We are in respectful agreement with the view expressed by the Indian Supreme Court that the deductability of such expenses cannot be made dependent upon the success or otherwise of the defence, for the primary test is whether the expenses were incurred wholly and exclusively for the purpose of the business. Such a test can be applied independently of the outcome of the criminal proceedings. Now, in the instant case, the assessee incurred the expenses in question on defending two of its employees who were prosecuted for acts arising out of the ordinary course of the business of the assessee, and the primary purpose of incurring the expenses was to protect the good name of the business and to preserve the goodwill of the employees. The assessee being a public limited company was not itself faced with any penal consequences as a result of the prosecution. On these facts and circumstances the Tribunal was right in holding that the legal expenses were incurred wholly and exclusively for the purpose of the business of the assessee, and were thus deductible under section 10 (2)(xvi) of the Act.

11. The reference is answered accordingly and the parties are left to bear their own costs. Reference answered.