By TIOL News Service

BANGALORE, SEPT 26, 2018: THE Issue - Whether 'distributable surplus' arising to an excise licencee out of manufacture & sale of liquor, which is liable to be compensated to a liquor conglomerate is only an 'application of income' and not a 'diversion of income at source by over riding title' in favour of such conglomerate. YES IS THE VERDICT.

Facts of the case:

The assessee company is engaged in manufacturing liquor glass. During the course of its assessment, the AO had disallowed "Distributable Surplus" paid by assessee to DIAGEO INDIA PRIVATE LTD, which was a subsidiary and Group Company of DIAGEO Plc, a UK based Liquor Conglomerate, as an 'allowable expenditure' in the hands of assessee u/s 37. In addition, the AO also held that the said income was earned out of manufacture & sale of liquor by the assessee which held the Excise Licence from the State Government, which had the monopoly and exclusive privilege of carrying on the trade of liquor and gives only licences under the provisions of the Karnataka Excise Act to certain persons upon the terms and conditions stipulated in the Licence under the said Act and there was no ‘diversion of such income’ from assessee to DIAGEO by overriding title and the assessee had to meet its tax obligations under the Income tax Act before applying the net income after tax in meeting its contractual obligations under the Agreement with DIAGEO.

On appeal, the CIT(A) observed that the distributable surplus paid by the assessee in terms of the said Agreement with DIAGEO was nothing, but the amounts to which Diageo was entitled to receive over the expenses to be borne by them, leaving behind the real income to which the assessee was entitled to in accordance with the relevant clauses of the governing agreements and therefore could not be disallowed on the ground that the same was to be considered as application of income. This finding of the CIT(A) was upheld by the ITAT.

High Court held that,

++ there is no dispute in principle that only real income of assessee can be brought to tax under the provisions of the Income Tax Act, but what is real assessable income is an intricate mixed question of fact and law. The trade of liquor and its manufacture and sale is unlike any other trade or business in India. It is a monopoly of the State and the State Legislatures have framed separate excise enactments for control and regulating such business of its own monopoly and therefore, under the stringent and strict conditions the Excise lincences are issued upon payment of high privilege fees to the State to manufacture and sell liquor of various types. Admittedly, the Assessee in the present case was the Excise Licencee under the provisions of the Karnataka Excise Act, and DIAGEO had no Excise Licence in its name from the State during the relevant assessment period. The business of manufacture & sale of liquor is closely controlled and regulated by the State Government including its storage, bottling, wastage, retail and wholesale sales thereof. The exclusive purchaser in the present case was a State Corporation, namely, KSBCL and therefore, such end to end control of the State Government under whose licence, the assessee CHAMUNDI alone was to manufacture & sell the liquor, it cannot be said by any stretch of imagination that such a business was being done exclusively for and on behalf of the third party, viz. DIAGEO, who was not at all subject to any control under the Excise Act. The income or business profits taxable under the Income Tax Act, naturally arose out of the said business activity of manufacture and sale of liquor only. Merely because the DIAGEO is a Brand owner and a big liquor business entity of UK, whose Indian Subsidiary DIAGEO had a private arrangement like the present one with the assessee and it provided not only right of user of Brands, Trademarks and Labels, but also provided some Raw Materials and concentrates and the Working Capital etc., it does not mean that the present assessee was either only an agent or a benami of DIAGEO;

++ the question therefore, that the ‘distributable surplus’ arising out of that business which is liable to be paid or made over to DIAGEO by way of compensation or benefit to DIAGEO under the said Agreement is nothing but an ‘application of income’ by CHAMUNDI and not a ‘diversion of income at source by over riding title’ in favour of DIAGEO. In the considered opinion of this Court, it is only ‘application of income’ and not ‘diversion of income’ by overriding title at source. The terms of the Agreement are very carefully crafted and intelligently drafted and they may at first blush give an impression of an overriding title over income in favour of DIAGEO, but on a closer and deeper scrutiny, it is nothing but a devious diversion, falling short of the legal prerequisites for taking it out of the ambit and charge of the Income Tax Act in the hands of assessee. The source of income as indicated is the manufacture and sale of liquor under the Excise Licence, where DIAGEO has no privity or locus. Therefore, whatever income is generated out of the said business has to be first taxed in the hands of the Excise Licencee and after payment of the Income-tax, the ‘distribution of surplus’ between the two parties, is their discretion and if the assessee gets its share of total profits only to the extent of Rs.45/- per Case in the name of bottling charges and DIAGEO takes the entire remaining balance as per the Agreement, that distribution of surplus between the two parties to the contract has no effect and overriding impact on the taxability part of the entire income arising or accruing firstly, in the hands of assessee CHAMUNDI for the period in question. In the opinion of this Court, the ‘diversion of income at source’ and ‘business expenditure’ u/s 37 are contradiction in terms and both contradictory claims cannot be made by assessee even in the alternative. The ‘diversion of income’ or rather ‘distribution of surplus’ under the Agreement required to be made by the assessee to DIAGEO is only after the income is brought to tax in the hands of assessee and therefore the ‘distributable surplus’ which the assessee has debited in its P&L A/c and credited to the Account of the DIAGEO, cannot be claimed as a ‘business expenditure’ u/s 37 of the I-T Act;

++ for the A.Y 2012-13, the debit of ‘Distributable Surplus’ to Profit and Loss Account of Assessee was not made because by change of Accounting method, in the Escrow Bank Account opened in the name of DIAGEO to which Receipts on Sales were automatically swiped and credited in their Bank Account and after the operating expenses paid out of it, the Assessee did not have to separately pay such ‘Distributable Surplus’ to DIAGEO. However, again the said change of Accounting Method, the diversion of Receipts to DIAGEO will not escape the taxability in the hands of the Assessee CHAMUNDI. The meeting of the contractual obligations by assessee under the said Agreement is not in the form of expenditure but day-to-day swipe of the Receipts from the business activity but that swipe of Receipts also does not amount to ‘diversion of income by overriding title’ from CHAMUNDI to DIAGEO. The charge of Income-tax on the income arising and accruing in the hands of assessee cannot be allowed to fail either by the manner of bank accounts to be operated or by the entries made in the Books of Accounts or the method of Accounting adopted by the two parties to the contract. The two Appellate Authorities therefore clearly fell in error in not appreciating the legal effect of the peculiar nature of business under the State control and the effect of the Agreement in the given set of facts and circumstances of the case. The Tribunal was swayed by the terms of the said Contract, which are so intelligently drafted so as to give a make-believe impression that the Assessee is a mere job worker doing the bottling work only, whereas in the eyes of law, it being the exclusive Excise Licencee, was undertaking the entire business activity of manufacture and sale of liquor in its name and ownership. Therefore, the entire business activity done by CHAMUNDI in its name could not be said to be giving rise to the profits taxable in the hands of the DIAGEO.

(See 2018-TIOL-2014-HC-KAR-IT)