Burden of proof for sham partnership and deductibility of managerial and agency payments under business expenditure rules

A registered partnership's profits were not treated as the assessee's income because the revenue failed to prove that the firm was a sham; family links, shared premises and assistance from another concern were insufficient to displace the partnership's separate existence. Commission paid to factory and sales managers was held deductible because the payments were commercially expedient, reasonable and supported by the business conditions, including increased production and incentive-linked remuneration. Payments to selling agents were not deductible because the assessee failed to prove that any services were actually rendered, so the statutory test of business expenditure was not satisfied.

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Issues: (i) Whether the profits of Ambal Stores could be treated as the profits of the assessee on the footing that the partnership was not genuine; (ii) Whether the commission paid to the factory and sales managers was an allowable deduction; (iii) Whether the payments to the selling agents were expenditure laid out wholly and exclusively for the assessee's business.

Issue (i): Whether the profits of Ambal Stores could be treated as the profits of the assessee on the footing that the partnership was not genuine.

Analysis: The partnership was registered under section 26A of the Income-tax Act and was separately assessed on its profits. The materials relied upon by the revenue, including the family connection of the partners, the use of premises belonging to a partner's father, clerical assistance from an employee of another concern, and deposits with that concern, did not establish that Ambal Stores was a sham or that its profits legally accrued to the assessee. The burden lay on the revenue to show that the apparent state of affairs was unreal, and the record did not contain evidence sufficient to displace the partnership's separate existence.

Conclusion: The finding that Ambal Stores was not genuine was unsustainable, and the profits of that firm could not be assessed as the assessee's income.

Issue (ii): Whether the commission paid to the factory and sales managers was an allowable deduction.

Analysis: The commissions were paid under agreements with employees who were already receiving salary, dearness allowance and bonus. The governing test under section 10(2)(x) was commercial expediency judged with reference to the employee's pay and service conditions, the profits of the business, and the general practice in similar businesses. The Tribunal had ignored the statutory relevance of profits and had failed to consider the increase in production and the difficult working conditions that justified an incentive linked to profits. On the facts, the payments were reasonable and not shown to be excessive.

Conclusion: The commission paid to the managers was an allowable deduction, and the disallowance was set aside.

Issue (iii): Whether the payments to the selling agents were expenditure laid out wholly and exclusively for the assessee's business.

Analysis: For deduction under section 10(2)(xv), the assessee had first to establish that the amounts were actually expended for services rendered. In respect of each of the three selling agents, the finding was that no services were proved to have been rendered to the assessee in the relevant year. Once that factual foundation failed, the claim could not succeed under the statutory test of business purpose or commercial expediency.

Conclusion: The payments to the selling agents were not deductible.

Final Conclusion: The assessee succeeded on the genuineness of Ambal Stores and on the deductibility of the managers' commission, but failed on the claim relating to the selling agents' payments.

Ratio Decidendi: Where the revenue alleges that a registered partnership is a sham and that its profits belong to another assessee, the burden is on the revenue to prove by evidence that the apparent arrangement is unreal; and a deduction for remuneration or agency payments depends on proof of actual services and satisfaction of the statutory test of business expenditure, assessed on commercial expediency within the language of the governing provision.

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