Section 42 apportionment must be rational: contract negotiation in British India attracted tax, but 50% attribution was excessive.

Where a contract was negotiated and concluded in British India as an essential trading operation connected with the earning of profits, section 42(1) of the Indian Income-tax Act, 1922 applied even though the profits were realised in Cochin State. The profits therefore required apportionment under section 42(3) on a rational basis. The Madras HC held that the Tribunal's flat 50 per cent attribution to the British India operation was unsupported and arbitrary on the facts, because the relevant activity in British India was limited to negotiation and conclusion of the contract. Only ten per cent of the assessee's share of profits was attributable to that operation.

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Issues: (i) whether the profits from the contract business, though realised in Cochin State, attracted section 42 of the Indian Income-tax Act, 1922 because the contract was negotiated and concluded in British India; (ii) whether apportionment of 50 per cent of the assessee's share of profits to the British India operation was justified.

Issue (i): Whether the profits from the contract business, though realised in Cochin State, attracted section 42 of the Indian Income-tax Act, 1922 because the contract was negotiated and concluded in British India.

Analysis: The decisive question was not merely where the contract was entered into, but whether the activities carried on in British India constituted an essential trading operation. The contract was the product of negotiations in British India and formed part of the assessee's business activity. The remaining operations were carried on in Cochin, and the profits actually accrued there, but section 42 applied where a business operation within the taxable territories was connected with the earning of the profit. In that situation, apportionment under section 42(3) became relevant.

Conclusion: Section 42(1) applied, and there was justification for apportionment under section 42(3) of the Indian Income-tax Act, 1922.

Issue (ii): Whether apportionment of 50 per cent of the assessee's share of profits to the British India operation was justified.

Analysis: The only operation within British India was negotiation and conclusion of the contract. The Tribunal fixed 50 per cent without explaining any rational basis. The contract had special features and involved significant operations outside British India, so the share attributable to the British India activity had to be non-nominal but could not reasonably be as high as 50 per cent. On the facts, a ten per cent attribution was held to be appropriate.

Conclusion: Apportionment of 50 per cent was not justified, and only ten per cent of the assessee's share of profits could be attributed to the British India operation.

Final Conclusion: The reference was answered by holding that section 42 applied, but the Tribunal's 50 per cent apportionment was reduced to ten per cent on the facts.

Ratio Decidendi: Where a contract negotiated and concluded within the taxable territories forms an essential trading operation connected with the earning of profits, section 42 applies and profits must be apportioned on a rational basis, not arbitrarily.

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