Section 36(1)(ii) of the Income Tax Act, 1961 (‘Act’ for short) provides that any sum paid to the employee as bonus or commission for services rendered, where such sum would not have been payable to him as profits or dividend if it had not been paid as bonus or commission is deductible. This provision is an enabling provision allowing deduction o account of bonus or commission paid to employees. The said payment is to be made out of profits subject to the conditions mentioned in the section. Any expenditure incurred on account of payment of commission to a person other than an employee is not covered by this provision.
The reasonableness of payment or adequacy of services rendered by the employees is not relevant factors in deciding the allowability of deduction. It is also not necessary that the payment should be made commensurate to the rendering of services or there should be some extra services rendered for payment on account of bonus or commission. This concept has been confirmed by the Supreme Court in ‘Shahzada Nand and Sons V. Commissioner of Income Tax’ 1977 -TMI - 6511 – (SUPREME Court) held that Section 36(1) (ii) of the Income Tax Act does not postulate that there should be any extra services rendered by an employee before payment of commission to him can be justified as an allowable expenditure. If services were in fact rendered by the employee, it is immaterial that the services rendered by the employee was in no way greater or more onerous than the services rendered by him in the earlier years. Of course, the circumstances that no additional services were rendered by the employee, would undoubtedly be of some relevance in determining the reasonableness of the amount of commission but it would have to be considered along with other circumstances.
Any bonus or commissioner paid to non employees will be governed by the provisions of Section 37(1) which allow deduction on account of any expenditure which is incurred wholly and exclusively for the purpose of business subject to certain conditions. The criteria ‘wholly and exclusively’ is not relevant while considering deduction under Section 36(1)(ii).
In ‘Dalal Broacha Stock broking V. Additional Commissioner of Income Tax, Mumbai’ – (2011) 10 ITR (Trib) 357 (Mumbai) (SB) the assessee company during the relevant year had paid commission to the tune of Rs.40 lakhs to the three working directors. They are the only shareholders of the company and owned the entire share capital. During the assessment proceedings, the Assessing Officer asked the assessee to explain as to why the claim of expenditure on account of the commission should not be disallowed as the assessee earned substantial profits and the same amount could have been distributed as dividend. The assessee submitted that the commission was not in lieu of profit or dividend as the payments had been made to the directors for the hard work they had put in improving the profits of the company. The assessee company was bound to declare dividend compulsorily. Since it wanted to improve its net worth to attract FIIs the company was not declaring dividend. The three directors were holding shares at 50%, 25% and 25% and therefore the case the amount of commission had been distributed as dividend, they would not have got the same amount as dividend.
The Assessing Officer did not accept the contentions of the assessee and held as follows:
- The directors had distributed dividend in the form of commissioner and therefore the payment was covered by the exceptions provided in Section 36(1)(ii)’;
- The three employee directors were the only shareholders and they were also the decision making authorities;
- The commission payment was in lieu of dividend;
- The commission payment was a device for tax evasion;
- The payment of commission was not eligible for deduction under Section 36(1)(ii) and disallowed the same to the total income.
In the appeal filed before Commissioner of Income Tax (Appeals) the assessee had raised an additional ground that commission payment should be allowed under Section 37(1) of the Act. The Commissioner (Appeal) rejected the additional ground since there is specific provision under Section 36(1)(ii) regarding allowability of bonus or commission.
Before the Special Bench the assessee put forth the following arguments:
- The intention of the legislature was always to make allowances for bona fide expenditure incurred on account of payment of bonus or commission;
- Section 36(1)(ii) was an enabling provision to allow expenditure on account of bonus or commission;
- The head of expenditure was different from nature of expenditure;
- Not all expenditure incurred under the head ‘bonus or commission’ would be covered by the Section 36(1)(ii);
- Section 36(1)(ii) covered only commission paid to non shareholder employees as there was no possibility of paying dividend to such employees;
- The commission paid to shareholder employees will be covered under the provisions of Section 37(1) under which expenditure incurred wholly and exclusively for the purpose of business is allowable;
- There was no dispute that the expenditure incurred was wholly and exclusively for the purpose of business and, therefore, the same should be allowed under Section 37(1);
- The legitimate and bona fide expenditure incurred for the purpose of business could not be disallowed on the ground that the assessee was saving in taxes;
- There was no dispute regarding the rendering of services by the directors and the reasonableness of payment made to them;
- The payment of commission which was for services rendered by the directors should be allowed under the provisions of Section 37(1) and that, in such cases, the provisions of Section 36(1)(ii) had no application.
The Department submitting the following arguments:
- The decision of the shareholder directors to pay commission instead of declaring dividend was obviously with the intention to reduce profit for avoiding payment of taxes as the assessee company had derived tax advantage;
- The directors had not given any reasons for not paying dividend although there were substantial profits;
- The argument that the dividend was not paid to improve the net worth to attract FIIs was not supported by any evidence;
- The provisions of Section 36(1)(ii) were applicable even when no extra services rendered for payment of commission;
- There being specific provision in Section 36(1)(ii) any expenditure incurred on account of payment of bonus or commission to employee should be covered by the section and not under Section 37(1);
The special bench heard both sides. It held that the payment of dividend by a company is not compulsory and it is dependent upon the profitability and other conditions of the business. Therefore, in cases, where dividend is not payable, the payment of bonus or commission can be allowed as deduction in case of employee shareholders also under Section 36(1)(ii) as in that case it could not be said that payment of bonus or commission is in lieu of dividend. Thus the provisions of Section 36(1)(ii) are also applicable to share holder employees subject to the condition that payment is not made in lieu of dividend. The provisions of Section 36(1)(ii) can be split in two parts. The first part viz., ‘any sum paid to an employee as bonus or commission for services rendered’ is an enabling provision. This part applies to all employees. The second part is a disabling provision which provides that ‘if the sum so paid in lieu of profit or dividend’, it cannot be allowed as deduction. This part applies only to employees who are partners or shareholders. Thus, in so far allowability of expenditure on account of bonus or commission under Section 36(1)(ii) is concerned, it applies to all employees including shareholder employees. The disallowability is restricted only to partners and shareholders as only in those cases, payment could be in lieu of profit or dividend. The special bench, therefore, rejected the arguments of the assessee that the provisions of Section 36(1)(ii) apply only to non shareholder employees.
The legal position is that any expenditure on account of payment of commission to an employee will be allowable as deduction under the provisions of Section 36(1)(ii) irrespective of the fact whether the employee is a shareholder or not or whether the commission has been paid for some extra services or for the some services subject to the condition that the payment is not in lieu of dividend. In case extra services have been rendered for payment of commission, it will be one of the relevant factors to consider while deciding whether the case is covered by exception provided in Section 36(1)(ii) i.e., whether the payment of commission is in lieu of dividend. In the present case, no evidence is available on record to support the plea that the directors had rendered any extra services for payment of huge commission in addition to services rendered as an employee for which salary has been paid. No such evidence has been placed nor even the details of any such extra services have been given.
The special bench held that in view of the above discussions that 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 special bench further held that the provisions of Section 37(1) will not also be applicable in such cases.
The special bench dismissed the appeal of the assessee.
By: Mr. M. GOVINDARAJAN - September 2, 2011