My closely held company paid commission to its three working directors, who are also its only shareholders. The Assessing Officer says s.36(1)(ii) bars it because no dividend was declared. Is that right?
The Mumbai Special Bench held it was. Where the recipients are shareholder-employees and, on the facts, a reasonable management would have declared dividend, the commission is 'in lieu of dividend' and s.36(1)(ii) disallows it — and s.37(1) cannot be used as an alternative route to allow the same payment.
Decided by the ITAT (D.K. Agarwal JM, N.V. Vasudevan JM and Rajendra Singh AM (Special Bench, Mumbai 'D' Bench)) on 2011-06-22, reported as I.T.A. No.5792/MUM/2009, assessment year 2006-07; Income Tax Appellate Tribunal, Mumbai, Special Bench; order pronounced in open court on 22 June 2011. It bears on section 36(1)(ii), section 37(1) of the Income Tax Act 1961, in Deductions & Disallowances, Assessment & Scrutiny and How Tax Law Is Read matters.
This is the decision every Assessing Officer relies on for a director-shareholder bonus in a private company, and its reach is wider than it first looks: the Bench held that 'payable' in s.36(1)(ii) does not mean statutorily or legally payable, but that dividend would have been declared by any reasonable management on the facts, so the absence of a dividend declaration is the trigger rather than the defence. It also held that adequacy of services is irrelevant and reasonableness ceased to be a requirement from AY 1988-89 — so the familiar 'but he rendered extra services' argument does not save the claim once the payment is found to be in lieu of dividend. The taxpayer's answer is not to argue services but to attack the 'in lieu of dividend' finding on arithmetic: see CIT v Career Launcher India Ltd (Delhi High Court, 2012) in this library, where the directors' shareholding would have yielded MORE as dividend than they received as bonus, and the disallowance failed.
Binding on the AO and CIT(A) within the Tribunal's jurisdiction. Persuasive elsewhere.
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The assessee company paid commission of Rs 1,20,00,000 to three working directors who were also its only shareholders and its decision-making authorities. No dividend was declared. The Assessing Officer worked out that had dividend been paid, the company would have borne tax of about Rs 36 lakhs on the increased income plus dividend distribution tax of about Rs 15 lakhs, whereas by routing the amount as commission the directors paid only about Rs 36 lakhs, so about Rs 15 lakhs of tax was avoided. He held the payment was in lieu of dividend and disallowed it under s.36(1)(ii), rejecting the assessee's case that the commission was for services rendered and comparable to market rates. The Commissioner (Appeals) upheld the disallowance. Because a coordinate Bench had decided the assessee's own case for AY 2005-06 the other way, the question 'Whether on the facts and circumstances of the case, the payment of commission to the extent of Rs.1,20,00,000/- is disallowable under the provisions of section 36(1)(ii)' was referred to a Special Bench. The assessee also claimed the amount in the alternative under s.37(1).
The reference was answered against the assessee and the appeal was dismissed. The payment of commission of Rs 1.20 crores to the three working directors was in lieu of dividend and was not allowable as a deduction under s.36(1)(ii) (para 7.20). The alternative claim under s.37(1) also failed: a payment of bonus or commission to an employee falls to be tested only by s.36(1)(ii) and not by s.37(1) (para 8.2). The appeal of the assessee was dismissed (para 8.3).
The Bench split s.36(1)(ii) into two limbs. The first — 'any sum paid to an employee as bonus or commission for services rendered' — is an enabling provision applying to all employees, including shareholder-employees. The second, disabling, limb operates only where the sum would otherwise have been payable as profit or dividend, and therefore bites only on partners and shareholders; the assessee's argument that the clause applies only to non-shareholder employees was rejected (para 7.6). On services, the only requirement is that some services be rendered; adequacy is not a relevant consideration, and no extra or additional services need be shown, following the Supreme Court in Shazada Nand & Sons; reasonableness ceased to be a requirement under the clause as amended from AY 1988-89 (paras 7.7 and 7.8). On the crucial word 'payable', the Bench refused to read it as statutorily or legally payable, since dividend is discretionary and such a reading would produce absurd results; it means that dividend would have been declared by any reasonable management on the facts, considering profitability and other relevant factors (para 7.8). Applying that test to a company whose only shareholders were the three recipients, the commission was held to be in lieu of dividend (para 7.20). On the alternative claim, the Bench followed the jurisdictional High Court in Subodh Chandra Poppatlal v. CIT (24 ITR 586), decided under s.10(2)(x) of the 1922 Act, which corresponds to s.36(1)(ii): where an expenditure falls under that provision its validity can only be determined by the tests laid down there and not by those in s.10(2)(xv), which corresponds to s.37(1) (para 8.2).
the payment of commission of Rs.1.20 crores to the three working directors was in lieu of dividend and the same is not allowable as deduction under section 36(1)(ii)
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Handle my notice → Ask a CA on WhatsAppThe Mumbai Special Bench held it was. Where the recipients are shareholder-employees and, on the facts, a reasonable management would have declared dividend, the commission is 'in lieu of dividend' and s.36(1)(ii) disallows it — and s.37(1) cannot be used as an alternative route to allow the same payment. This was decided by the ITAT (D.K. Agarwal JM, N.V. Vasudevan JM and Rajendra Singh AM (Special Bench, Mumbai 'D' Bench)) and bears on section 36(1)(ii), section 37(1) of the Income Tax Act 1961. It is reported as I.T.A. No.5792/MUM/2009, assessment year 2006-07; Income Tax Appellate Tribunal, Mumbai, Special Bench; order pronounced in open court on 22 June 2011. This is the decision every Assessing Officer relies on for a director-shareholder bonus in a private company, and its reach is wider than it first looks: the Bench held that 'payable' in s.36(1)(ii) does not mean statutorily or legally payable, but that dividend would have been declared by any reasonable management on the facts, so the absence of a dividend declaration is the trigger rather than the defence. It also held that adequacy of services is irrelevant and reasonableness ceased to be a requirement from AY 1988-89 — so the familiar 'but he rendered extra services' argument does not save the claim once the payment is found to be in lieu of dividend. The taxpayer's answer is not to argue services but to attack the 'in lieu of dividend' finding on arithmetic: see CIT v Career Launcher India Ltd (Delhi High Court, 2012) in this library, where the directors' shareholding would have yielded MORE as dividend than they received as bonus, and the disallowance failed. If it applies to you, the first step is this: Work out, for the year in dispute, what each director-shareholder would have received as dividend on his actual shareholding, and compare it with the commission or bonus paid to him — a mismatch between the two profiles is the single strongest fact against an 'in lieu of dividend' finding.
The assessee company paid commission of Rs 1,20,00,000 to three working directors who were also its only shareholders and its decision-making authorities. No dividend was declared. The Assessing Officer worked out that had dividend been paid, the company would have borne tax of about Rs 36 lakhs on the increased income plus dividend distribution tax of about Rs 15 lakhs, whereas by routing the amount as commission the directors paid only about Rs 36 lakhs, so about Rs 15 lakhs of tax was avoided. He held the payment was in lieu of dividend and disallowed it under s.36(1)(ii), rejecting the assessee's case that the commission was for services rendered and comparable to market rates. The Commissioner (Appeals) upheld the disallowance. Because a coordinate Bench had decided the assessee's own case for AY 2005-06 the other way, the question 'Whether on the facts and circumstances of the case, the payment of commission to the extent of Rs.1,20,00,000/- is disallowable under the provisions of section 36(1)(ii)' was referred to a Special Bench. The assessee also claimed the amount in the alternative under s.37(1). The matter was decided on 2011-06-22 by the ITAT (D.K. Agarwal JM, N.V. Vasudevan JM and Rajendra Singh AM (Special Bench, Mumbai 'D' Bench)). On those facts the ITAT held as follows. The reference was answered against the assessee and the appeal was dismissed. The payment of commission of Rs 1.20 crores to the three working directors was in lieu of dividend and was not allowable as a deduction under s.36(1)(ii) (para 7.20). The alternative claim under s.37(1) also failed: a payment of bonus or commission to an employee falls to be tested only by s.36(1)(ii) and not by s.37(1) (para 8.2). The appeal of the assessee was dismissed (para 8.3).
The Bench split s.36(1)(ii) into two limbs. The first — 'any sum paid to an employee as bonus or commission for services rendered' — is an enabling provision applying to all employees, including shareholder-employees. The second, disabling, limb operates only where the sum would otherwise have been payable as profit or dividend, and therefore bites only on partners and shareholders; the assessee's argument that the clause applies only to non-shareholder employees was rejected (para 7.6). On services, the only requirement is that some services be rendered; adequacy is not a relevant consideration, and no extra or additional services need be shown, following the Supreme Court in Shazada Nand & Sons; reasonableness ceased to be a requirement under the clause as amended from AY 1988-89 (paras 7.7 and 7.8). On the crucial word 'payable', the Bench refused to read it as statutorily or legally payable, since dividend is discretionary and such a reading would produce absurd results; it means that dividend would have been declared by any reasonable management on the facts, considering profitability and other relevant factors (para 7.8). Applying that test to a company whose only shareholders were the three recipients, the commission was held to be in lieu of dividend (para 7.20). On the alternative claim, the Bench followed the jurisdictional High Court in Subodh Chandra Poppatlal v. CIT (24 ITR 586), decided under s.10(2)(x) of the 1922 Act, which corresponds to s.36(1)(ii): where an expenditure falls under that provision its validity can only be determined by the tests laid down there and not by those in s.10(2)(xv), which corresponds to s.37(1) (para 8.2). In the words reproduced by the source cited on this page: "the payment of commission of Rs.1.20 crores to the three working directors was in lieu of dividend and the same is not allowable as deduction under section 36(1)(ii)" The decision followed or applied Subodh Chandra Poppatlal v. CIT (24 ITR 586) (Bom.) — followed on the exclusivity of s.36(1)(ii) over s.37(1); CIT v. Shazada Nand & Sons (108 ITR 358) (SC) — applied on adequacy of services.
It was decided by the ITAT on 2011-06-22 and is reported as I.T.A. No.5792/MUM/2009, assessment year 2006-07; Income Tax Appellate Tribunal, Mumbai, Special Bench; order pronounced in open court on 22 June 2011. Binding on the AO and CIT(A) within the Tribunal's jurisdiction. Persuasive elsewhere. A Tribunal decision binds the assessing officer and the Commissioner (Appeals) within that Tribunal's jurisdiction, and is persuasive before other benches. It is not binding on a High Court, and a contrary co-ordinate bench decision will be argued against you, so check whether the point has been taken the other way before you build a reply around it. On section 36(1)(ii), section 37(1), the practical question is whether the facts of your own notice match the facts of this case closely enough for the same rule to apply.
It helps the department, and it appears in this library for that reason — you need to know what the Assessing Officer will cite against you. The reference was answered against the assessee and the appeal was dismissed. The payment of commission of Rs 1.20 crores to the three working directors was in lieu of dividend and was not allowable as a deduction under s.36(1)(ii) (para 7.20). The alternative claim under s.37(1) also failed: a payment of bonus or commission to an employee falls to be tested only by s.36(1)(ii) and not by s.37(1) (para 8.2). The appeal of the assessee was dismissed (para 8.3). It arises in Deductions & Disallowances, Assessment & Scrutiny and How Tax Law Is Read matters, on section 36(1)(ii), section 37(1) of the Income Tax Act 1961, and was decided by D.K. Agarwal JM, N.V. Vasudevan JM and Rajendra Singh AM (Special Bench, Mumbai 'D' Bench). Before relying on it, read the source linked on this page and check whether it has since been distinguished, overruled or overtaken by an amendment to the Income Tax Act. In practice the steps that follow from it are these. Put the board resolution, the terms of employment and the basis on which commission is computed on record before the Assessing Officer, not for the first time before the Tribunal. Do not rest the case on extra services rendered: the Special Bench held adequacy of services is not a relevant consideration once the disabling limb is attracted. Do not plead s.37(1) in the alternative expecting it to work — the Bench held, following Subodh Chandra Poppatlal, that a bonus or commission to an employee is tested only under s.36(1)(ii). If dividend WAS in fact declared in the year, say so at the threshold; the Special Bench expressly proceeded on a year in which no dividend was declared.
Validity check could not be completed. The holding is independently corroborated by the Bombay High Court's judgment in Dalal & Broacha Stock Broking Pvt. Ltd. v. ACIT (Writ Petition (L) No.419 of 2013, decided 7 May 2013), which records the Special Bench holding verbatim in the reasons for reopening AY 2008-09 and upholds the reopening on the strength of it — that judgment did not decide the s.36(1)(ii) merits and expressly kept them open. An appeal in the Bombay High Court, ITA No.2395 of 2011, M/s. Dalal & Broacha Stock Broking Pvt. Ltd. v. Addl. CIT Range 4(1), was disposed of as withdrawn on 18 March 2021; the appeal number is consistent with an appeal from this Special Bench order but the withdrawal order does not identify the order appealed from, so this cannot be stated as fact. No systematic later-treatment check was carried out. No source could be cited for that finding. Checking whether an authority still stands matters as much as knowing what it held: a decision may be overruled on one point and survive on another, or the provision it interprets may have been amended since. Read the source and the editor's note on this page before relying on it in a reply to an Assessing Officer or in an appeal.
Paragraph 7.6 of this order was transcribed differently on two independent passes (?type=print gave 'The disallowability is restricted to only partners and shareholders as only in those cases, payment could be in lieu of profit or dividend'; /docfragment/ gave 'The disallowability is restricted to only partners and shareholders in cases where payment could be in lieu of profit or dividend under section 36(1)(ii).'). Because the two passes differ, nothing from para 7.6 is treated as a quotation here, and the key_quote is taken from para 7.20, which came back character-for-character identical on both routes. Paragraph 7.7 reproduces a passage from the Supreme Court in Shazada Nand & Sons (108 ITR 358); that passage is the Supreme Court's, not the Special Bench's. The order runs to paragraph 8.3, which is the disposal. DATE: indiankanoon's own title line for this document reads "on 16 December, 2010", but the order itself ends "Order pronounced in open court on 22.6.2011." and the document header prints "Date of Pronouncement: 22.6.2011". The pronouncement date in the order has been preferred and 16 December 2010 should not be cited as the date of this decision. A third pass on para 7.6 returned a wording different again from the two recorded above ("We are unable to accept such argument which can be relevant only when the payment of dividend to shareholders is compulsory…"), which confirms the decision to quote nothing from that paragraph. This library shows the verification state of every entry openly. This entry has not yet been read in full by a chartered accountant. The summary reflects the sources listed on this page. Read the source before you rely on it in a reply to an Assessing Officer or in an appeal before the Commissioner (Appeals) or the Income Tax Appellate Tribunal.
The reference was answered against the assessee and the appeal was dismissed. The payment of commission of Rs 1.20 crores to the three working directors was in lieu of dividend and was not allowable as a deduction under s.36(1)(ii) (para 7.20). The alternative claim under s.37(1) also failed: a payment of bonus or commission to an employee falls to be tested only by s.36(1)(ii) and not by s.37(1) (para 8.2). The appeal of the assessee was dismissed (para 8.3).
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