Proper head for classification of Directors remuneration - a discussion and some suggestions in view of changed circumstances due to levy of FBT.

[DEV KUMAR KOTHARI]

Whether, directors remuneration should be assessed as income under the head "salaries" or "other sources" or as "business or professional income" has been a matter of controversy. Depending on relationship and the nature of work done and capacity and manner of working is important to determine proper head of income. Though in overall context it may not make much difference but the revenue for the revenue on all India bases, however, revenue is agitating the issue to gain some petty advantages like:

a. disallowing standard deduction u/s 16 (discontinued from assessment year 2006-07) , by treating remuneration as income from other sources and not under the head 'salaries'.

b. Deny benefit of concessional  valuation of perquisites under the head salaries by treating income as from other sources.

c. deny benefit of set off of past business losses and also current business loss from A.Y. 2005-06, by treating directors remuneration as  income under head 'salary' or other sources instead of as professional income from business or  profession or vocational income , as claimed by assessee.

Thus we find that inconsistent views are being adopted to deny some or other relief. In such cases total revenue implication is not significant , but as a matter of policy to disallow claims of assessee the authorities take inconsistent view for insignificant revenue benefit. In turn assessee and revenue both have to indulge in litigation.

To recapitulate related concepts some fundamentals about company and its shareholders and directors are briefly discussed below:

Shares are movable property:

In case of companies shares are a movable property easily transferable from one person to other and a transfer of shares does not affect the life of the company. In case of private limited company there are some restrictions on transfer of shares but they are freely transferable to any person who is not disapproved by the board of directors of the company in accordance with the articles of the company. In practice we find change of hands  and management of private companies as well as public companies.

Company is a separate person and can employ persons:

Company is a separate juristic person and it can employ any person for doing its work in different capacities like an employee, agent.  The employee or agent including directors of company are agent of the company  and are accountable to the company. Therefore, there is definitely a relationship of master and servant between the company and  its agents by whatever name called like a director , managing director, officer, CEO or simply an employee or agent.

Directors are responsible to company:

Directors are responsible to company. If a director works even without any remuneration still he will be accountable because working as a director of the company may be considered as a consideration for the work performed by him. Accepting office of director itself binds director for his obligations as a director while acting for the company. Even if a director is not paid any salary or even board meeting fees (as we find in large number of privately held companies) still he will be accountable for his conduct in relation to   company's work.  If the director works in a professional capacity then also he will be responsible to the company. Though the matter may be different from point of view of taxation of remuneration received in professional capacity.  In that case though he is accountable to the company but still the income derived by him by exercising professional skills in an independent capacity will be his professional receipts.

Directors v. Board of Directors

A director of a company may act as an independent director as an executive director/ managing director / whole time director or simply as director of the company.  But the company is controlled by the board of directors and not by any individual director. The control of company vests in the board and not in nay individual director.  There are many vital powers which can be exercised only by the board of directors and sometimes only under a specific delegation from the shareholders in a general meeting.  The Companies Act  provide various situations in which different powers are to be  exercised only in a board meeting.  Therefore, a single director of company can not be said to have control over the company.  In case of a private company there must be at least two directors and in case of a public company there must be at least three directors.  The board exercise its powers as per the provisions of Companies Act, the memorandum of associations and the articles of association of the company and also special or ordinary resolution passed by the shareholders from time to time imposing certain restrictions on the power of the board.  The board of directors can grant powers or curtail powers of directors.  Sometimes, board may grant powers to two or more directors jointly or severally.  Therefore, it is clear that an individual even if he beneficially holds entire share holding of the company can not be said to be  owner of the company and he does not controls company.  Though in his capacity as a shareholder by exercising his voting rights he can decide who will be director.  However, once a board of director is in place (that must be for any company) any individual director works only under superintendence and control of the board of directors.  Therefore, there can be relationship of employer and employee or a superior and a sub-ordinate.

Superintendence of the Board:

As per provisions of the Companies Act as well as the articles of association of company and also as per general practice a whole time director or managing director or any director working independently for the company works under control and supervision of the Board of directors and he has to report the work done to the Board and the Board of directors reports to the shareholders at general meetings. A director is appointed by the board or by share holders and director derives his authority from the board, or shareholders in accordance with the articles of association of the company and the provisions of companies Act.

Voting rights:

Suppose in a company two brothers are directors and hold majority (but not full) stake.

For arguments sake and to examine real strength let us suppose that there arises some differences between the two brothers, and each one wants to control the company and to oust the other one. In that case the brother who can get support from other shareholders and have more  votes  in his favour  may be able to oust the other from the company's management or to reduce his strength in the board.

Judgment of Calcutta High Court:

Sajid Mowjee  v. Income-tax Officer [ 2005] 148 TAXMAN 502 (CAL.)

In this case the facts are analysed as follows;

An analysis

The no. of shares held by assessee in the company     -     24254         49.57%

The no. of shares held by father of the assessee          -     24101         49.26%

No. of   shares held by other 40 shareholders              -         570           1.17%

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Total shares of company                                              -     48925        100%

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Thus, the assessee, personally had less than controlling stake in the company.  However, by including the shares of his father (or some other persons) it can be said that along with his father (or some other shareholders) he had controlling stake in the company but not independently.

The assessee was a whole-time director and his father was also a director of the company.  His appointment as whole time director was approved by the Board of directors as well as share-holders in their meetings.

The assessee was appointed as a whole-time director of a company.  The assessee received remuneration for the services performed for the company and claimed that such receipts of remuneration would fall under the head 'Salary' as per section 15.  The Assessing Officer taking the view that the assessee was having full control over the affairs of the company and he held substantial number of shares as well as paid up capital and, therefore, no relationship of employer and employee existed between the assessee and the company, taxed the remuneration received by the assessee under the head 'Income from other sources', and disallowed benefits allowable under the head 'salaries'.  On further appeal, that order was affirmed by the Commissioner (Appeals) and the Tribunal. Thus the assessee had to approach the high court with the following questions:

(a)     Whether the respective sums shown as salary in the return for the assessment years 1993-94, 1995-96 and 1996-97 shall be treated as income assessable under section 15 or under section 56 of the Income-tax Act, 1961?

(b)    Whether on the facts and circumstances of the case, the conclusion of the Learned Tribunal that there was no relationship of employer and employee between the Company and the assessee is perverse and / or sustainable in law?

Submission on behalf of the Appellant / Assessee:

By the resolution under which the assessee was appointed whole-time director and his remuneration was fixed in the general meeting in which the resolution was adopted and the  Memorandum and Articles of Association of company provide that there was relationship of employer and employee for the purpose of treating the remuneration received by the assessee under the head 'salary' for the purpose of section 15 of the Income-tax Act, 1961.

Assessee's counsel  relied on the decision in Ram Singh v. Union Territory of Chandigarh [2004] 1 SCC 126, CIT v. L. Armstrong /Smith [1946] 14 ITR 606 (Bom.), Ram Prashad v. CIT [1972] 86 ITR 122 (SC) = [2008 -TMI - 6354 - SUPREME Court], Jaswant Rai v. CWT [1977] 107 ITR 477 (Punj. & Har.) and Gulabrai Hanumanbux v. CWT [1992] 198 ITR 131 (Gauhati).

Submission on behalf of the Respondent / Department:

From the Memorandum and Articles of Association it appears that the company took over the erstwhile partnership business carried on by this assessee and his father and that the company was only a camouflage.

In fact, it was partnership firm, as would appear from the subscription of shares which predominantly shows that the entire control vested with the father and son.

The appointment of the assessee as whole-time director could not be terminated.  The right to terminate is a right of the employer.  This may not be factors for ascertaining the relationship.  By reason of the holding of the shares of the assessee, the board could never take the resolution to terminate his employment or appointment.

Therefore it is a fit case for lifting the veil to ascertain the characteristics of the company and discover the real entity of the assessee and the device adopted by the assessee for the purpose of obtaining benefits within the scope and ambit of the Act.

The revenue's counsel relied on:

State of Gujarat v. Raman Lal Keshav Lal Soni AIR 1984 SC 161 [Para 6.1], CIT v. Smt. Dipali Goswami [1985] 156 ITR 36/[1986] 25 Taxman 39 (Cal.) [Para 6.1] and CIT v. Manmohan Das [1966] 59 ITR 699 (SC) [Para 6.2].

After hearing both sides the court inter alia observed and held as follows:

Nature of Receipt is relevant:

It is not the character of the recipient but the character of the receipt that is material for the purpose of determining as to under which head the receipt should be treated for the purpose of income-tax.

Scope of S.15- the head "salaries":

Section 15 enumerates the salaries chargeable to income-tax under the said head. As per Explanation 2  any salary, bonus, commission or remuneration, by whatever name called, due to, or received by a partner of a firm from the firm shall not be regarded as salary for the purpose of the said section.  The Explanation do not excluded the receipt by a director from a company, private limited or public limited from the scope of S.15.

 Admittedly, a company whether private limited or public limited is a juristic person.

 Whether it can be a camouflaged or not cannot be questioned so long it continues to be a company registered under the Companies Act, 1956 either as a private limited or a public limited one.

The definition of salary in section 17(1)(iv) includes any fees, commission, perquisites or profits in lieu of or in addition to any salary or wages.

 If the income is one under the head 'Salary', in that event, the deductions provided under section 16 from the salaries becomes available to an assessee.

From the resolution of the company, it appeared that the assessee was co-opted and was elected as a director in the annual general meeting.  The board of directors called an extraordinary general meeting suggesting the resolution appointing the assessee, fixing the remuneration of the assessee comprising of house rent allowance and allowance for his service as a whole-time director of the company.  The said resolution had been passed unanimously in the subsequent meeting.

Thus, it appeared that the board had sanctioned the said remuneration.

 Whether a director is an employee or not is dependent on the nature and character of the appointment and the terms and conditions or other provisions contained in the memorandum and articles of association.  It appeared that the remuneration of directors for part-time or whole-time service to the company shall be determined in accordance with law and subject to the provisions of the articles and of the Companies Act, 1956. 

Clause 21(m)  in the Articles of Association of the company specified the powers of the directors and the board of directors which are subject to provisions of the Companies Act.Further while defining the powers of the directors, it was mentioned that the control of the company should be vested in the board which shall be entitled to exercise such powers including those mentioned in sub-clauses (a) to (u) of clause 21 of the Articles.

Those were powers of the board of directors under which a managing director or whole-time director could be appointed upon such terms and on such remuneration as the board might determine.  It had specified that the remuneration of the managing director or whole-time director might be by way of salary or commission or participation in profits or by any or all of those modes.

The control of the company was vested in the Board of Directors and the directors are subject to superintendence of the board.

Therefore, the remuneration allowed to the assessee would very well be treated as salary within the terms of the said memorandum and articles of association.

Admittedly, the company is a juristic person and it is governed by the board of directors and is altogether an independent entity other than the directors.  The board of directors may control the company but such directors might have dual capacity, one as member of the board as director and the other as an employee of the company or being in charge of the administration of the company as an independent administrator in the capacity of a director.  The appointment of one of the members of the board of directors as whole-time director involved certain kind of responsibility to be carried out in terms of his appointment whether specified or not.  The Board has a right to appoint.  It has a right to give directions, it may not have right to take disciplinary action.  But it has right to prescribe conditions of service.  It has right to determine the nature of the duties to be performed by the whole-time directors.  It has right to determine the salary to be paid.  Therefore, the company could be an employer while appointing one of its director as whole-time director on a particular remuneration and prescribing the terms and conditions of his appointment.

In common parlance, the whole-time director may not be an employee but even then the character of the receipt or remuneration having come within the definition of salary under section 17(1)(iv) being a fee or remuneration by whatever name it is called and not being excluded by the Explanation 2 to section 15.

The appointment showed that the board of directors had power to appoint and determine the fees or remuneration, etc.  The assessee had a dual capacity.  He was entrusted to manage the business.  The contract was of employment and not for employment.  Therefore, having regard to the material placed, the receipt came under the head 'Salary' as discussed above.

The remuneration received by the assessee could not be treated to be anything other than income under the head 'Salary'.  The income could not be treated as income from other sources.

Thus, the income was assessable under section 15 and not under section 56 and for the purpose of income-tax, there was a relationship of employer and employee between the company and the whole-time director and the finding of the Tribunal was perverse and could hot be sustained in law.

Directors investment in companies as a part of adventure in nature of trade or commerce:

In some situations it can be found that the directors make investment in companies as an adventure in nature of trade. They hold shares in companies, provide loans, stands guarantor for loans obtained by companies and actively work for the company. They try to improve working of the company so that in future they can get remuneration by way of salary or commission and better price of shares. In such cases the activity will be an adventure in nature of trade or commerce. Therefore, expenses incurred by director as interest on capital borrowed to invest in company, incidental expenses while performing duties, losses suffered in discharge of guarantee will be admissible as business sand professional expenses incurred in the course of vocation and profession of director. The remuneration may be considered under the head "salary" if it is just by performing certain duties as employee. However, if the remuneration is as a result of adventure undertaken by the director directly by investing money and indirectly through company by doing business activities, and the remuneration is linked with performance of company like as commission on profit or sales, then such income may be more appropriately be considered as business income.

Directorship as profession -case before Calcutta High Court:

In CIT V Rajeeva Lochan Kanoria (1994) 208 ITR 616 Calcutta high court considered issue relating to activity of director and also allowability of expenses incurred by way of interest on capital borrowed for purchasing shares in companies controlled by the assessee. The court held as follows:

That directorship is nothing but a vocation. The assessee was admittedly a director of several controlled companies. The activity of controlling, managing, administering, and financing companies is nothing but a business/ professional/ vocational activity. A businessman, like the assessee in this case, did not purchase shares of different companies for acquiring controlling interest therein only for earning dividends. Acquiring of controlling interest in companies and managing, administering, financing and rehabilitating companies under control were for business and / or professional purpose. Interest on capital borrowed for investment in shares was deductible.

This judgment of Calcutta High court is of February 21, 1994, the author had dealt with the matter of Shri Kanoria before the Tribunal and as per information provided by Mr. kanoria, he has not received any intimation about appeal by revenue before the Supreme Court.  Thus the judgment has been accepted by the revenue ( not yet challenged).

Controlling interest may be held in association with others:

A director whether as a promoter or not may hold controlling stake in company independently or in association with others. Promotion of companies or their project may be undertaken in association of several persons- relative, friends and associates. This will not change the character of activity. In fact in that case the element of business activity is further enlarged because one has to prepare others to associate with him in an adventure. Therefore, promotion of companies or projects in association with others will not change the nature of activity and it will remain to be business activity. 

Directorship and profession tax:

Directorship is regarded as 'profession', vocation or calling in law of profession tax of various states. A person who is a director is required to obtain registration certificate and pay profession tax on that basis. As a director a person has to devote time in activities. Directorship also require some special qualification or experience, it also require certain financial, contractual and legal commitments by the person. Therefore, directorship is an organized and systematic activity and is clearly a professional activity.

Proper head of income:

From above discussion it appears that the following heads of income may most appropriately be applied to different type of remuneration or profit of directors:

Salary - in case of salary of employee director, independent directors .working directors having responsibility and reporting system just like any other employee.

Business or professional income- fees for attending board meetings or meeting of committee or general meetings,  commission, profit sharing, remuneration received in professional capacity for doing professional work, etc.

In view of the author 'other source' is not at all appropriate head of any type of income received by directors of companies.

Revenue should not dispute on petty matters:

It appears that instead of disputing on petty matters it would be better if the option is given to the assessee to decide proper head of income in view of peculiar facts as to risks taken by him, activity performed by him, time devoted by him, investments made by him, association of other persons used by him etc.

Disallowance for perquisites to directors:

Many times A.O. disallow certain expenses as related to directors or their relatives on the ground of excessive or not for wholly and exclusively for the business. Courts have held that such disallowance is not proper because company and directors are different persons, company provide perquisites on ground of commercial expediency Still some disallowances on ground of personal use is in vogue.

Now after levy of FBT, the revenue collect tax from employer ( company), therefore, after FBT is levied such disallowances should not be made.

Fringe benefit and tax in hands of employees or directors:

The FBT is in fact a tax paid by company which is income tax  on income of employees (and others), which they receive by way of fringe. The general understanding is that the items on which FBT has been paid shall not form part of taxable income of employees. This is also provided by S. 17 (2) (vi) accoding to which any fringe benefit on which FBT is paid will not be perquisite taxable under residuary category.

Therefore, under law it is recognized that the fringe benefits are provided in the course of business, as they are provided collectively, therefore, collection of tax from employees is difficult. For ease in determination and collection of tax on such incomes FBT has been levied. Therefore, the sums in respect to which FBT has been paid by company the following aspects need clarifications:

That the corresponding value shall not be taxable in hands of employee including directors and other beneficiaries of fringe.

That relevant sums shall not be disallowed in the hands of employer on the ground of not related to business or being excessive or similar other reasons.