Is Retrenchment compensation an allowable deduction under Income Tax?

Section 37 of the Income Tax Act pertains to general allow ability of business expenditure while computing Profits or Gains from Business or Profession. According to Section 37(1), any expenditure, not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”.

Let us refer to the case of Sasson J. David Co P. Ltd v. CIT (1979), where the main issue under consideration was whether the payments made by the assessee company to the employees and the director by way of compensation for termination of service were allowable as business expenditures under section 37(1) or not.

Facts of the Case:

The Company was an investment company and its shares were originally held either directly or through their nominees by Sir Percival David, Lady David and Mr. V. P. David (collectively referred to as ‘Davids’).
A resolution approving the recommendation made by the directors to pay the employees retrenchment compensation and compensation for termination of employment and also additional retrenchment compensation and compensation for termination of employment in the case of some of them and to terminate their services was passed.
Thereafter an agreement was entered into between Davids and Tata Sons Ltd. (the Tatas) agreeing to sell the 1000 shares held by Davids or their nominees in the Company in favour of Tatas or their nominees for a sum of Rs. 155 lacs.

The said agreement inter alia provided that the sum voted by the Company for payment of gratuities and/or as compensation for loss of employment to existing directors and employees of the Company with respect to their services up to and inclusive of March 31, 1956 and a further amount of Rs. 16,188, payable to the Managing Director, should be paid in accordance with the resolution by the Company and the amount so paid should be deducted from the purchase price of Rs. 155 lacs agreed upon.
The appellant paid Rs. 1,64,899, which included Rs. 16,188 paid to the managing director in lieu of 6 months’ notice, Rs. 21,200 paid towards compensation for termination of pension allowance, and Rs. 16,885, the first of five annual payments as compensation to the director.
These amounts were claimed as a deduction under section 37(1).
These payments resulted in a substantial reduction in the wage bill as a consequence of the retrenchment.

Order passed by ITO

The ITO denied the deduction on the ground that the services of the managing director and the employees were terminated not because of business expediency but because Tata’s made it a pre-condition under the agreement and therefore, it could not be considered as allowable under section 37(1).

Orders passed by Appellate Authorities and High Court (HC)

The additions were confirmed by the Commissioner (Appeals).
The Tribunal confirmed that the expenditure was not incurred for the purpose of the business and further held that no deduction could be allowed since it was made to benefit the third party.
On a reference, the High Court held that only the two amounts of Rs. 21,200 and Rs. 16,188 were allowable as deductions and that the balance of Rs. 1,27,511 paid to the employees and a director was not allowable as a deduction since the expenditure had not been incurred by the company for commercial reasons.
Aggrieved with the order of the HC, assessee appealed before the Supreme Court

Observations of Supreme Court (SC)

The assessee-company was neither dissolved nor was its business undertaking sold.
It continued to exist as a juristic entity even after the transfer of its shares by Davids in favour of Tatas.
No doubt that on account of such transfer of shares, the transferees gained control on the assessee company, but neither Davids nor Tatas derived any direct benefit out of the payment of retrenchment compensation even though such retrenchment might have facilitated the transfer of shares.
HC wrongly placed more emphasis on the motive with which the amount was expended than the fact that the expenditure was incurred in connection with the business of the assessee company.
On appeal reversing the judgement of the HC, the SC held that even assuming that the motive behind the payment of the compensation was that the terms of the agreement between the Davids and Tatas for the sale of the shares should be satisfied, as long as the amount of Rs. 1,27,511 was laid out wholly and exclusively for the purpose of the business of the appellant, there was no reason for denying the deduction.
The appellant company continued to function even after its control passed on to the Tatas and the expenditure in question was laid out for the purpose of the company’s own trade and not for the trade of the Tatas who was only its shareholder.

As a result of the expenditure, the appellant company was in fact benefited by reduction in its wage bill.
It could not be said that the Tatas was in any way benefited financially because of the deduction in the consideration payable by it for the shares.
The expression ‘wholly and exclusively’ did not mean ‘necessarily’.
Ordinarily, it was for the assessee to decide whether any expenditure should be incurred in the course of his or its business.
The fact that somebody other than the assessee also benefited by the expenditure should not come in the way of an expenditure being allowed by way of deduction if it satisfied otherwise the test laid down by law.

The sum of Rs. 1,27,511 was, therefore, held to be expended by the appellant on the ground of commercial expediency and in order to indirectly facilitate the carrying on of its business, and was, therefore, allowable as a deduction

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