Sri Lanka Law Reports
(1978-79-80) 1 SriLR.
DAVOODBHOY v. COMMISSIONER-GENERAL OFINLAND REVENUE
SAMARAKOON, C.J., SAMERAWICKREMA, J. AND WANASUNDERA. J.
S.C. APPEAL NO. 9/79. BRA 365 COURT OF APPEAL (SC) C A. 1/77JULY 3. 4, 5, 1979.
Inland Revenue Act. sections 79(7) and 52 – Agreement by partner to share withchildren his profits of a business partnership – Whether agreement is artificial andfictitious – Does it form a sub-partnership which is liable to be taxed – Does it resultin a diversion of profits by overriding title -Is the assesses liable to be assessed forthe entirety of the profits.
The appellant Abasbhoy Davoodbhoy was one of five partners of a firm carrying onbusiness under the name of 'Abdul Hassen Davoodbhoy' and was entitled to onefifth share of its profits. In order to provide for his children he entered into anagreement (A IJ with them, whereby they agreed "to be partners in regard to the onefifth share of the profits and losses of the said Abasbhoy Davoodbhoy." Theagreement stated that the share of the capital and the goodwill in the said businesswhich was the property of the appellant was to remain his separate asset. The onlyasset of this venture therefore was the one fifth share of the profits received by theappellant. The agreement A1 and the rights claimed under it were rejected by theAssessor in terms of section 79(7) of the Inland Revenue Act and the whole of theone fifth share of the profits was assessed as the income of the appellant and not asthe income of the parties to the agreement A1.
SC Davoodbhoy v. Commissioner-General of Inland Revenue 23
Appeals to the Commissioner General of Inland Revenue and the Board of Reviewwere dismissed. On a case stated by the Board of Review the matter was heard bythe Court of Appeal and answered against the appellant. The Court of Appealgranted the appellant leave to appeal to the Supreme Court as substantial questionsof law were involved.
It was contended on behalf of the respondent that A1 was "artificial and fictitious",that’ it did not create a sub-partnership but was merely a family arrangement andthat the one fifth share of the profits was the income of the appellant which shouldbe assessed in terms of section 52 of the Inland Revenue Act since, A1 results in
an application of income and not a diversion of same. It was argued that, for adiversion of income there must be a transfer of its source.
The agreement Al is not "artificial and fictitious". It incorporates a familyarrangement which is genuine and very common in our society. The accounts showthat this agreement has been acted upon and profits divided accordingly. It cannotbe rejected under 79(7) of the Inland Revenue Act.
An arrangement to share profits only, can constitute in law, a partnershipbetween the parties to the agreement. A1 created a "sub-partnership" which termis merely a convenient name used in law and in commercial circles to describe apartnership which is dependent on another partnership. Such an agreement isperfectly valid in civil law and must therefore attract the provisions of the InlandRevenue Act.
The question whether the income of the appellant has been diverted byoverriding title or whether it is a mere application by him must in the main dependon the very nature and effect of the transaction. In the instant case, the one fifthshare of profits derived from Abdul Hassen Davoodbhoy accrued to the benefit ofseveral partners. The entirety of it was not the income of the appellant alone and hecould not deal with it as he liked without incurring legal liability in terms of Al. Foralienation of income there need not be an alienation of its source. The appellantwas therefore wrongly assessed. The parties to the agreement A1 are liable to beassessed under section 52 of the Inland Revenue Act in respect of their portions ofthe divisible profits.
Cases referred to:
Snook v. London & W. Riding invest. Ltd.. (1967} 1 AH E.R. 518; (1967)2W.LR. 1020.
Raja Bejoy Singh Dudhuria v. Commissioner of Income Tax. Bengal. (1933)1I.T.R. 135.
Murtidhar Himatsingka and Another v. Commissioner of Income TaxCalcutta. (1966) 62 / T.R. 323.
Commissioner of Income Tax v. Sitaldas Tirathdas. (1961) 41 T.L.R. 367I.T.R.219.
Official Trustees of West Bengal v. Commissioner of Income Tax (1979)116I.T.R. 219.
APPEAL from a judgment of the Court of Appeal.
S. Ambalavanar, with C. Thangarajah and Miss M.P.C. Joseph, for the appellant.
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(1978-79-80) 1 SriL.R.
G.P.S. de Silva. Additional Solicitor-General, with K.C. Kamatasabayson, StateCounsel, for the respondent.
Cur, adv, vult.
July 20,1979SAMARAKOON, C.J.
The appellant in this case was granted leave to appeal to this courtby the Court of Appeal as it was of the opinion that "Substantialquestions of law are involved" in the interpretation of theinstrument which is the subject matter of the assessment of tax.There is in the Pettah an old firm by name Abdul HassenDavoodbhoy carrying on business at No. 50, Dam Street. Thefounder of the business died leaving 5 sons and the five sonsowned and ran the business in partnership, each partner beingentitled to 1/5 share of the profits. Disputes seem to have arisenamong the partners on the question of employment in the firm ofthe children of each of the partners. Females were not eligible foremployment. The sons of each of the partners were admitted asemployees but the salary paid to each was paltry on account of thenecessity to maintain high profits. Abasbhoy Davoodbhoy(assessee) was one of the five partners and his only son Asgar wasemployed at a salary of Rs. 150 per month. Asgar considered thispoor remuneration for the work he was doing and thereforeAbasbhoy Davoodbhoy decided to remedy this situation. He, hisson Asgar (28 years) his daughters, Hassina (23 years), Nafeesa(19 years) and Rasheeda (IS years) entered into an agreement inwriting signed by all parties which was produced marked A1. It isdated 1st April, 1965. By the said agreement the father andchildren agreed "to be partners in regard to the share of the profitsand for losses of the said Abasbhoy Davoodbhoy". It statedcategorically that "the share of the capital and the goodwill in thesaid business which is the property of Abasbhoy Davoodbhoy shallremain the separate asset of Abasbhoy Davoodbhoy". The onlyasset of this venture, therefore, was the 1 /5 share of the profitsreceived by Abasbhoy. The manner of sharing the profit and lossesis set out in clause 4 of A1. Clause 7 of A1 gave Abasbhoy the rightto vary and/or terminate the interests of any one or all of the par-ties with a month's notice. This document and the rights claimedunder it were rejected by the assessor for the year of assessment1966/67. He assessed the whole of the 1/5 share as the incomeof Abasbhoy (assessee) and not as the income of the parties to theagreement A1. The amount of tax in dispute is Rs. 18,521.
The assessee appealed to the Commissioner-General of InlandRevenue who dismissed the appeal. The assessee then appealed to
Davoodbhoy v. Commissioner-General of Inland Revenue
the Board of Review. The Board also dismissed the appeal butstated a case to the Supreme Court under the provisions of section102 of the Inland Revenue Act. This was heard by the Court ofAppeal and answered against the assessee. It has now reachedthis court on leave to appeal being granted by the Court of Appeal.
The Commissioner-General held inter alia that "a sub-partnership like the one created by A1 does not find a place" in thescheme of taxation under the Inland Revenue Act. He also heldthat it was artificial and fictitious and therefore rightly rejected bythe assessor in terms of section 79(7) of the Inland Revenue Act. The
Board of Review also held that the agreement was artificial andfictitious and also held that the income was the sole income of theassessee as the income was the income of the assessee alone andhad not been diverted before reaching the assessee. The Court ofAppeal while agreeing that A1 was artificial and fictitious also heldthat the 1/5 share of profits was the income of the assessee aloneand the agreement resulted in the application of that income andnot a diversion by overriding title.
I will deal first with the finding that the agreement is artificialand fictitious. Section 79(7) of the Inland Revenue Act, No. 4 of1963, reads as follows:-
"(7) Where an assessor is of opinion that any transactionwhich reduces or would reduce the amount of tax payable byany person is artificial or fictitious or that any disposition isnot in fact given effect to. he may disregard any such tran-saction or disposition and the persons concerned shall beassessable accordingly."
If A1 was rightly rejected under the provisions of section 79(7)then there was no necessity to go into the question whether it wasa sub-partnership recognised by the revenue laws or even to con-sider the nice question as to whether there was merely an applica-tion of income or whether it was a diversion of income by overrid-ing title. In view of the rejection under section 79(7) the latterexercise was futile. Counsel for the assessee contended that it waswrongly rejected while State Counsel maintained that it was in factartificial and fictitious. Is it in fact unreal and a sham? State Coun-sel pointed to a number of factors. He referred to the evidence ofHassima before the Board of Review where she stated:-
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"The sub-partnership did not transact any business. Myfather formed this partnership not to do any business, butonly to share his profits with us, his children."
Following the reasoning of the Court of Appeal, State Counselpointed to the provisions of clause 6 of A1 and stated that AccountBooks will show only profits and losses. But this is a wrong con-struction of the clause, as it does not provide for such kind ofaccounting. No doubt the assessed has the right to terminate theagreement and until such termination he remains the owner of thecapital and goodwill. This is a perfectly legal document. It incorpo-rates a family arrangement by which a father is seeking to providefor his children – a most natural desire, and if so minded, the child-ren could even enforce it in law. This kind of family arrangement isnot only genuine but very common in our society. To brand it asartificial and fictitious is unwarranted and unjust. It incorporates aperfectly legitimate family transaction. "For acts and documents tobe a 'sham' with whatever legal consequences to follow from this,all the parties thereto must have a common intention that the actsand documents are not to create the legal rights and obligations
which they give the appearance of creating" per Diplock, II. in
Snook v. London and W. Riding Invest., Ltd. (1) The accounts up to31.3.1968 show that this agreement has been acted upon andprofits divided in terms of A1. I therefore reject the contention thatit is artificial and fictitious. It cannot be rejected under the provi-sions of section 79(7) of the Inland Revenue Act.
The Commissioner-General was of the opinion that a sub-partnership of the kind established by A1 found no place in thescheme of taxation under our Inland Revenue Act. If that be sothen a perfectly legitimate source of income is not taxable. Doesthe assessee then go scot free? If so then the Act needs amend-ment to make it taxable. The Commissioner-General states that the"partners in A1 have not come together to carry on a trade or busi-ness in partnership" and therefore chargeability to tax of a partner-ship under the provisions of section 52 does not arise. The term"sub-partnership" is merely a convenient name used in law and incommercial circles to describe a partnership which is dependent onanother partnership commonly called a "principal partnership".These are merely nomenclature that have no significance in law.They are well known to the law of Sri Lanka. The position in Eng-lish law which should also be the applicable law here, is describedby Lind ley as follows:-
"A sub-partnership is, as it were, a partnership within apartnership: it presupposes the existence of a partnership to
Davoodbhoy v. Commissioner-General of inland Revenue
which it is itself subordinate. An agreement to share profitsonly constitutes a partnership between the parties to theagreement. If, therefore, several persons are partners andone of them agrees to share the profits derived by him with astranger, this agreement does not make the stranger apartner in the original firm. The result of such an agreementis to constitute what is called a sub-partnership, that is tosay, it makes the parties to it partners inter se; but it in noway affects the other members of the principal firm. In thelanguage of civilians, Socius mei socii, socius meus non est.In Ex p. Barrow, Lord Eldon puts the law on this subject veryclearly: "I take it," he says, "to have been long since estab-lished that a man may become a partner with A where A andB are partners and yet not be a member of that partnershipwhich existed between A and B. In the case of Sir Chas.Raymond, a banker in the city, a Mr. Fletcher agreed with SirChas. Raymond that he should be interested so far as toreceive a share of his draw profits of the business, andwhich share he had a right to draw out from the firm of Raymond& Co. But it was held that he was no partner in that partner-ship; had no demand against it; had no account in it; andthat he must be satisfied with a share of the profits arisingand given to Sir Chas. Raymond." (Vide Lindley on Partner-ship, Ed. 12. p. 99).
It will be seen that an agreement to share profits only, can con-stitute in law, a partnership between the parties to the agreement.The Commissioner-General therefore correctly referred to A1 as asub-partnership. A transaction such as the one in A1 is perfectlyvalid in Civil Law and must therefore attract the provisions of theRevenue Act. It is not necessary to go further into this aspect inview of the opinion I have formed with regard to the chargeabilityfor the income derived by the sub-partnership.
The case stated by the Board of Review poses the questions"Whether the assessee is liable to be assessed under section 52 inrespect of the 1/5th share of the divisible profits of Abdul HassanDavoodbhoy for the year of assessment 1966/67" or "Whether theassessee's children are liable to be assessed under section 52 inrespect of any portion of the divisible profits?" and "whether theincome of Asgar accruing to him by virtue of the agreemententered into by him on 3rd April, 1965, and embodied in agree-ment 'A' can be assessed as the income of the assessee?" StateCounsel contended that this 1/5th share of the profits was thestatutory income of the assessee accruing to him from the
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business of Abdul Hassan Davoodbhoy and therefore the assessor"shall apply" the provisions of section 52 to make this assessment.The crucial section, he contends is section 52 (4) which leaves himno alternative but to assess it as the income of the assessee as thisis not a diversion of income but by the operation of A1 only anapplication of income. He further contended that A1 is not a sub-partnership but merely a family arrangement. I have already heldthat A1 creates a sub-partnership. The question for decision thenis whether A1 results in a mere application of profit or whetherthere is a diversion of income by overriding title. State Counselargued that for a diversion of profits there must be a transfer of thesource of income. He cited a statement contained in 'The Law andPractice of Income Tax" by Kanga and Palkivalla (Vol. 1, Ed. 6, p.97) which reads as follows :-
"If a person has alienated or assigned the source of hisincome so that it is no longer his, he may not be taxed uponthe income arising after the assignment of the source."
By way of illustration he cited the decision of the Privy Council inthe case of Raja Bejoy Singh Dudhuria v. Commissioner of IncomeTax, Bengal (2). The appellant (assessee) in this case had succeededto ancestral property on the death of his father. His step mother -sued him for maintenance and a consent decree was entered bycourt declaring that the lady's maintenance was a legal liability ofthe appellant and that this maintenance was a charge on theancestral estate in the hands of the appellant. The appellant hadpaid the lady a sum of Rs. 9,900 in terms of the decree in the yearof assessment 1924-25 but this was taxed on his income and nodeduction was allowed. In allowing the appeal and the deduction claimedthe Privy Council said
"In the present case the decree of the court by charging theappellant's whole resources with a specific payment to hisstep-mother has to that extent diverted his income from himand has directed it to his step-mother; to that extent what hereceives for her is not his income. It is not a case of theapplication by the appellant of part of his income in a partic-ular way, it is rather the allocation of a sum out of hisrevenue before it becomes income in his hands."
This is a case where by virtue of a decree the assessee wascompelled to allow a part of his income to be diverted to his step-mother. A clear case of diversion by overriding title.
Davoodbhoy v. Commissioner-General of Inland Revenue
The question whether the income of an assessee has beendiverted by overriding title or whether it is a mere application byhim must in the main depend on the very nature and effect of thetransaction in each case. In this case it is the agreement A1. Coun-sel for the assessee contended that by reason of the fact thatlosses, and not merely profits, were shared by the partners, it wasconclusive proof that there is an alienation of income. Motives,good or bad, he stated, were irrelevant. He relied strongly on thedecision in the case of Murlidhar Himatsingka and Another v.Commissioner of Income Tax, Calcutta (3). This was a case decidedby the Supreme Court of India on July 19, 1966. The facts werethese. Murlidhar was carrying on business under the name andstyle of "Fatehchand Murlidhar". He was also a registered partnerof Messrs. Basantal Ghanshyamdas having 2 as. 8ps. share. On21.12.1949 he entered into a Deed of Partnership with two sonsand one grandson whereby they agreed to become partners of"Fatehchand Murlidhar" and contributed capital in the sums of Rs.10,000, Rs. 5,000 and Rs. 5,000 respectively. Clause 5 of the part-nership agreement reads as follows:-
"The profits and losses for the share of the said MurlidharHimatsingka as partner in the said partnership firm ofBasantal Ghanshyamdas shall belong to the present part-nership and shall be divided and borne by the parties heretoin accordance with the shares as specified hereafter, but thecapital with its assets and liabilities will belong exclusivelyto Murlidhar Himatsingka the party hereto of the first partand the parties hereto of the second, third and fourth partsshall have no lien or claim upon the said share capital orassets of the party hereto of the first part in the business ofthe said Messrs. Basantal Ghanshyamdas."
Clause 10 provided that the profits and losses of the partnership"including the shares of the profits and losses of the said firm ofBasantal Ghanshyamdas" shall be divided in the proportions the-rein set out. Clause 13 gave the sole control and direction of thebusiness to Murlidhar. For the year of assessment 1955-56 thetaxing officer included the income from the share in BasantalGhanshyamdas in the individual assessment of Murlidhar Himat-singka. On a case stated the Supreme Court decided that theagreement created a sub-partnership stating the reasons thus –
"In arriving at this conclusion we attach importance to thefact that losses were also to be shared and the right toreceive profits and pay losses became an asset of the firm,Fatehchand Murlidhar."
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The Court cited with approval the test laid down by Hidayatullah, J.in Commissioner of income Tax v. Sitaldas Tirathdas (4) whichreads as follows: –
"In our opinion, the true test is whether the amount soughtto be deducted, in truth, never reached the assessee as hisincome. Obligations, no doubt, there are in every case, but itis the nature of the obligation which is the decisive fact.There is a difference between an amount which a person isobliged to apply out of his income and an amount which bythe nature of the obligation cannot be said to be a part of theincome of the assessee. Where by the obligation income isdiverted before it reaches the assessee, it is deductible; butwhere the income is required to be applied to discharge anobligation after such income reaches the assessee, the sameconsequence, in law, does not follow. It is the first kind ofpayment which can truly be excused and not the second.The second payment is merely an obligation to pay another aportion of one's own income, which has been received andis since applied. The first is the case in which the incomenever reaches the assessee, who even if he were to collectit, does so, not as part of his income, but for and on behalf ofthe person to whom it is payable."
Applying this test the Supreme Court held that the income wasthat of the partnership of "Fatehchand Murlidhar" and not that ofMurlidhar (assessee}. The reasoning was as follows:-
"The question then arises whether the interest of the sub-partnership in the profits received from the main partnershipis of such nature as diverts the income from the originalpartner to the sub-partnership. Suppose that A is carrying ona business as a sole proprietor and he takes another personB as a partner. There is no doubt that the income derived byA after the date of the partnership cannot be treated as hisincome; it must be treated as the income of the partnershipconsisting of A and B. What difference does it make in prin-ciple where A is not carrying on a business as a sole proprie-tor but as one of the partners in a firm? There is no doubtthat there is this difference that the partners of the sub-partnership do not become partners of the original partner-ship. This is because the law of the partnership does notpermit a partner, unless there is an agreement to the con-trary, to bring strangers into the firm as partners. But as faras the partner himself is concerned after the deed of agree-ment of sub-partnership, he cannot treat the income as hisown. Prior to the case of Cox v. Hickman, (I860) 8 H.L. Cas,
Davoodbhoy v. Commissioner-General of Inland Revenue
268, sub-partners were, even liable to the creditors of theoriginal partnership. Be that as it may, and whether he istreated as an assignee within section 29 of the Indian Part-nership Act, as some cases do, a sub-partner has definiteenforceable rights to claim a share in the profits accrued toor received by the partner."
State Counsel contended that this case was wrongly decided andinvited this Court to so hold. I do not agree. Murlidhar's case hasnot taken the narrow view looking solely for alienation of thesource of income as there are other means of alienating income. Ithas taken the larger view based on the nature of the obligation onaccount of which the partner (assessee) could not "treat theincome as his own". After the agreement the income "was nolonger his" (Kanga and Palkhivala, p. 97). In effect it decided that thesub-partnership agreement affected the very source of Murlidhar'sincome in the first partnership. Murlidhar's case has beenapproved by the Indian Supreme Court in Official Trustee of WestBengal v, Commissioner of Income Tax (5). I am of the view thatthis is the correct approach in deciding the legal effect of At. The1/5 share of the profit derived by the assessee from Abdul HassenDavoodbhoy ceased to be the assessee's sole property. He couldnot deal with it or spend it as he liked without incurring legal liabil-ity under A1. The whole of it was not income accruing to hisbenefit (vide section 12 of the Inland Revenue Act, No. 4 of 1963).It accrued to the benefit of several partners. The whole of it wasnot the real income of the assessee alone. It must be noted that inMurlidhar's case the profits from the firm of Basantal Ghanshyam-das did not form the capital of the firm of "Fatehchand Murlidhar".It was only income of the latter. One of the reasons given by theCourt of Appeal for deciding that Murlidhar's case was notapplicable to the case under consideration is that in Murlidhar'scase the partners contributed capital. This fact has little relevancewhen we consider the real principle on which that decision wasbased. In Murlidhar's case as in this case the profits did not formany part of the capital and was treated solely as income of thepartnership. For the above reasons I hold that the assessee waswrongly assessed.
The Commissioner-General feared that if this appeal is upheldtaxpayers would resort to this device to reduce their tax. I am aliveto this problem. Indeed it could be resorted to in such a way as toavoid payment altogether. But this is a matter for the legislature toremedy and not a matter for us to consider as interpreters of thelaw as it exists today.
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I set aside the order of the Court of Appeal and answer the ques-tions posed in the case stated as follows:-
Agreement A1 is not artificial and/or fictitious and has beenacted upon.
Income derived by Asgar on A1 is his separate income andmust be assessed separately from that of the assessee.
The assessee will be entitled to costs here and in the Court ofAppeal.
SAMERAWICKREMA, J. – I agreeWANASUNDERA. J. – I agree
DAVOODBHOY v. COMMISSIONER-GENERAL OF INLAND REVENUE