For the purpose of computation of income and taxing purposes, section 14 classifies

income into 5 heads:

A.-Salaries

B. Income from house property

C. Profits and gains of business or profession

E.- Capital gains

F.- Income from other sources

A. SALARIES

Firstly, salaries and Deductions from salaries are defined under section 15 and 16 of

Income Tax Act 1961.A deduction is an expense that can be subtracted from a taxpayer's

“gross income” in order to reduce the amount of income that is subject to taxation. Now,

section 15 lays down the criteria for computation of this “gross income”. It states that

the following income of the assesse shall be “chargeable” under section 15

a. any salary due from current or former employerin the previous year, whether paid

or not

b. any salary paid/allowed to him in the previous year by/ on behalf of current or

former former employer, before it became due

c. any other arrears not charged to income-tax for any earlier previous year

d. Explanation to the sections includes salary paid in advance within the ambit of the

section for that year

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 e. Explanantion 2 states that any bonus, commission or other remuneration of similar

nature shall not be included in the section, whether received or receivable

Now, section 16 lays down the deductions that have to be made from the gross

income to compute taxable income.

a. Standard deduction of 50,000 or amount of total salary, whichever is lower

b. For people in govt. Service, a deduction in respect of an entertainment allowance

specifically granted by an employer – either ⅕ of total income or rs.5,000

whichever is lower

c. a deduction of any sum paid on account of a tax on employment

Before proceeding, it is also significant to refer to section 7(1), which lays down an

illustrative list of items to be included within “salary”, it says that tax shall be payable

by an assessee under the head "Salaries" in respect of any:

1. salary or wages

2. Annuity

3. pension or gratuity

4. fees, commissions, perquisites

5. profits in lieu of, or in addition to, any salary or wages , received or receivable

from the Government companies and authorities or any private employer

6. advances by way of loan or otherwise of income chargeable under this head shall

be deemed to be salary due on the date when the advance is received:

Provided that the tax shall not be payable in respect of any sum deducted from the salary

payable by or on behalf of the Government to any individual, being a sum deducted in

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accordance with the conditions of his service, for the purpose of securing to him a

deferred annuity or making provision for his wife or children provided that the sum so

deducted shall not exceed [one-fifth] of the salary:

Provided further that where tax is deductible at the source under section 18, the assessee

shall not be called upon to pay the tax himself unless he has received the salary without

such deduction.

The application of the aforesaid sections 15 and 16 has been examined at length by the

Supreme Court in the case of Ram Pershad v. C.I.T (1972). The issue at consideration

in this case director’s remuneration – there may be a relationship of an employer and

employee between the company and its managing director or a whole-time director, but

that is determined on certain facts. Now, for a clear understanding of this case, it is

important to discuss Head D i.e. section 28 of IT Act. As per this section, the following

come within income from PGBP (Profit & Gains from business & profession):

a. Profit from any business/ profession

b. perquisite/ benefit arising from business

c. Interest/Salary/Remuneration/Commission/Bonus received by Partner of a

firm

d. Sums received under an agreement for forbearance,

e. Sums received under Keyman Insurance Policy

Brief Facts

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 ● The assesse and his wife were managing directors of their company and were

entitled to certain allowances from the company. However, during the assessment

year, the company incurred loss and thus the assessee gave up his share of

commission that year,payable to him.

● He thus claimed that this amount should not be included in his income because the

amount had not accrued to him at all in the accounting year i.e. it is not taxable

under Section 7 or Section 10 of the Indian Income-tax Act.

Assesse’s primary contention

● That his relationship with the company is that of principal and agent, and not

master and servant; therefore he commission payable to him is income from

business and not salary.

Court’s analysis of nature of income

● The Court first noted that under section 7 of IT Act. “commissions” are

included in the salary of the assessee and are made taxable. Moreover. In light

of the decision given in Morvi Industried LTd. v. CIT, it is wellsetlled that

commissions are revenue receipts for taxing purposes. Thus, the Court stated that

the primary question that needs to be answered is:

Whether the 10% gross profits payable to the assessee under

the terms of the agreement appointing him as the Managing

Director is liable to be assessed as ‘salary’ or under the head

‘income from business’?

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● The Court observed that order to assess the income as salary it must be

held that there was a relationship of master and servant between the

company and the assessee i.e. employee must be subject to the supervision

and control of the employer in respect of the work that the employee has to

do However, the Court also noted that this test does not have a univerisal

application. The greater the amount of direct control over the person

employed, the stronger the conclusion in favour of his being a servant.

Similarly the greater the degree of independence the greater the possibility

of the services rendered being in the nature of principal and agent.

Therefore,a person who is engaged to manage a business may be a

servant or an agent according to the nature of his service and the

authority of his employment.

● MD has dual capacities as employee and agent: A director of a company

is not a servant but an agent inasmuch as the company cannot act in its

own person but has only to act through directors who qua the company

have the relationship of an agent to its principal. A Managing Director

may have a dual capacity. He may both be a Director as well as

employee. In light of the decision rendered in Anderson v. James

Sutherland (Peterhead) Limited, the Court held that to answer this

question. Articles of Association need to be examined, wherein it was

observed that MD is a party to a contract with the company, and this

contract is a contract of employment;

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 ● In Lakshminarayan Ram Gopal v. Government of Hyderabad. [25 ITR

449 (SC)] Bhagwati, J., speaking for the Court held that the assessee as

MD was an agent and not a servant, on the following grounds – the MD

does not have the power, inter alia, to assign the agreement,power of

sub-delegation of functions given to the agent etc.

● Hoever, on the contrary Kania J in CIT Bombay v. Armstrong Smith held

that MD was a servant (employee) of the company on the particular

facts of that case, as AoA in that case provided for a contractual

relationship of the assesse with the company – that all the other

directors were to be under his control and were bound to conform to his

directions in regard to the company’s business; that his remuneration was

to be voted by the company at its annual general meeting.In these

circumstances it was held that the remuneration was taxable under Section

7 and not under Section 12 of the Act. It was thus held that:

“...that a director of a company as such is not a servant of

the company but that does not prevent him from

entering into a contractual relationship with the

company, so that he also becomes entitled to remuneration

as an employee. This relationship can be established both

via service agreement as well as AoA.”

Construction of the AoA in the present case

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AoA provides that the assesse shall be the Managing Director of the company for 20

years on terms and conditions embodied in the agreement:

● Under the terms of the agreement he can be removed within the period of 20

years for not discharging the work diligently or if he is found not to be acting in

the interest of the company as MD.

● Subject to the aforesaid agreement, his remuneration (commision) shall be

finalised on the annual general meetings. (AGMs).

● He is also allowed to sign cheque on behalf of the company and sub-delgate his

powers. He shall work for the executions of the decisions that may be arrived at by

the Board.

● The test to be applied is not to be narrow in approach i..e it is not necessary that

the company should be in a position to dictate him daily on a continuous basis.

Therefore, the AoA indicate the nature of the control imposed by the company

upon the MD. The additional work which he can do as an agent or manager of the

company can be done on terms and conditions specified therein.The very fact

that apart from his being a Managing Director he is given the liberty to work

for the company as an agent is indicative of his employment as a Managing

Director not being that of an agent.

● The Court thus decided that the powers of the assessee have to be exercised

within the terms and limitations prescribed thereunder and subject to the

control and supervision of the Directors which is indicative of his being

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 employed as a servant of the company. Thus, the remuneration payable to him is

salary and is taxable under section 7.

C.I.T. v. L.W. Russel

Brief Facts

● The assesse was the employee of a society based in England, which started a

‘superannuation scheme’ via a trust deed (company pension plan for benefit of

employees), and the society would contribute ⅓ premium amount towards the

insurance premium payable by the trustees (i.e. employees) for arranging a

deferred annuity on thir superannuation.

● The Society credited that ⅓ amount to assesse’s account towards the premium

payable and the IT Officer included the said amount in the taxable income of the

respondent for the year 1956-57 under Section 7(1), Explanation 1 sub-clause (v)

of the Act.

Now, before proceeding, it is important to understand what are perquisites and

annuity for tax purposes.

● Perquisite is defined as a privileged gain or profit incidental to regular salary.

Perquisites are both taxable and exempt. The clause (v) of explanation to section

7(1) is relevant for the present case, which states that “perquisite includes any

sum payable by the employer, whether directly or through a fund to effect an

assurance on the life of the assessee or in respect of a contract for an annuity on

the life of the assessee.

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 ● An annuity is a contract between an individual and an insurance company in which

you make a lump-sum payment or series of payments and, in return, receive

regular disbursements, beginning either immediately or at some point in the future.

SECTION 7. (1)The tax shall be payable by an assessee under the head ‘salaries’ in

respect of any salary or wages, any annuity, pension or gratuity, and any fees,

commissions, perquisites or profits in lieu of, or in addition to, any salary or wages,

which are allowed to him by or are due to him, whether paid or not, from, or are paid by

or on behalf of, ... a company.... Explanation 1.- For the purpose of this section perquisite

includes. * * * * * (v) any sum payable by the employer, whether directly or through a

fund to which the provisions of Chapters IX-A and IX-B do not apply, to effect an

assurance on the life of the assessee or in respect of a contract of annuity on the life of

the assessee.

Question of Law

1. Whether the contributions paid by the employer to the assessee under the terms of

a trust deed in respect of a contract for a deferred annuity on the life of the

assessee is a ‘perquisite’ as contemplated by Section 7(1) of the Indian Income

Tax Act?

2. Whether the said contributions were allowed to or due to the applicant by or from

the employer in the accounting year?

3. Whether the deferred annuity aforesaid is an annuity hit by Section 7(1) and para

of Explanation 1 thereto?

Court’s Analysis of nature of Salary

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● Object of the Superannuation Scheme: The purpose is to provide for pensions to

its employees. It is achieved by creating a trust. The Trustees appointed thereunder

are the agents of the employer as well as of the employees and hold the moneys

received from the employer, the employee and the insurer.The Trustees are

enjoined to take out policies of insurance securing a deferred annuity upon the life

of each member, and funds are provided by contributions from the employer as

well as from the employees.

● Therefore,under the scheme the employee has not acquired any vested right in the

contributions made by the Society. Till the employee attains the age of

superannuation the employer’s share of the contributions towards the

premiums does not vest in the employee. At best he has a contingent right

therein. In one contingency (let’s say he is terminated from service for violation

of code of conduct) the said amount becomes payable to the employer and in

another contingency (let’s say, in the vent of his early death), to the employee.

● Now, the question that arises whether such a contingent right is hit by section

7(1)?

○ This section imposes a tax on the remuneration of an employee. It

presupposes the existence of the relationship of employer and

employee. It is argued that the premium payable falls within “perquisites”

mentioned in the section –The expression “perquisites” is defined in the

Oxford Dictionary as “casual emolument, fee or profit attached to an office

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 or position in addition to salary or wages”. Explanation 1 to Section 7(1)

of the Act gives an inclusive definition.

○ In this light, A combined reading of the substantive part of Section 7(1)

and clause (v) of Explanation 1 thereto makes it clear that the following

conditions have to be specified for it to be called “perquisite”

a. The employer allows a sum of money to the employee by or it

becomes due to hi, or that it is paid to enable him to effect an

insurance on his lifeThen, such amount amount would be liable to

tax.

b. The Court interpreted the expression “allowed'' as having a wider

connotation and any credit made in the employer’s account is

covered by it. The expression in the legal terminology is equivalent

to “fixed, taken into account, set apart, granted”. It takes in

perquisites given in cash or in kind or in money or money’s worth

and also amenities which are not convertible into money. It implies

that a right is conferred on the employee in respect of those

perquisites. The employer cannot allow a perquisite to an

employee if the employee has no right to the same. It cannot

apply to contingent payments to which the employee has no right

till the contingency occurs. In short, the employee must have a

vested right therein.

● Premium payable not persquiste

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○ In light of the foregoing discussion, the Court held that the amounts paid

by the Society to the Trustees under the Scheme are NOT perquisites

allowed to the respondent or due to him from the employer within the

meaning of Section 7(1) of the Act.

○ Till he reaches the age of superannuation, the amounts vest in the Trustees

and the beneficiary under the trust can be ascertained only on the happening

of one or other of the contingencies provided for under the trust deed.

○ Thus, the principle that unless a vested interest in the sum accrues to

an employee it is not taxable, applies to the present case.

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