A) ABSTRACT / HEADNOTE
The Supreme Court in Mazagaon Dock Ltd. v. The Commissioner of Income-Tax and Excess Profits Tax, [1959] 36 ITR 368 (SC) clarified the scope and application of Section 42(2) of the Indian Income-Tax Act, 1922. The judgment resolved the conflict surrounding the taxation of resident companies where profits were allegedly suppressed due to their close connection with non-resident entities. Mazagaon Dock Ltd., a resident company in India, repaired ships owned by its foreign parent companies without charging profits as per a pre-existing agreement. The Income-Tax Officer invoked Section 42(2) asserting that such arrangements, driven by their close financial relationship, denied the resident company profits it should ordinarily have earned. The Court examined the meaning of “carrying on business with” and the chargeability under Section 42(2), ultimately ruling that the tax liability under this provision attaches to the resident company’s business, even if no actual profit accrued. The Court also expounded the wide import of “business” in tax statutes, affirming that organized commercial dealings, even under non-profit arrangements, fall within the ambit of taxable business connections.
Keywords:
Indian Income-Tax Act, Section 42(2), business connection, non-resident, resident company, notional profits, tax liability, Supreme Court, corporate tax, business arrangement.
B) CASE DETAILS
i) Judgement Cause Title:
Mazagaon Dock Ltd. v. The Commissioner of Income-Tax and Excess Profits Tax
ii) Case Number:
Civil Appeal No. 381 of 1956
iii) Judgement Date:
May 12, 1958
iv) Court:
Supreme Court of India
v) Quorum:
Justice Venkatarama Aiyar, Justice Gajendragadkar, Justice A.K. Sarkar
vi) Author:
Justice Venkatarama Aiyar
vii) Citation:
Mazagaon Dock Ltd. v. The Commissioner of Income-Tax and Excess Profits Tax, [1959] 36 ITR 368 (SC)
viii) Legal Provisions Involved:
Section 42(2) of the Indian Income-Tax Act, 1922
ix) Judgments overruled by the Case (if any):
None
x) Case is Related to which Law Subjects:
Income Tax Law, Corporate Taxation, International Taxation, Business Law
C) INTRODUCTION AND BACKGROUND OF JUDGEMENT
Mazagaon Dock Ltd., incorporated under the Indian Companies Act, operated as marine engineers and ship repairers. It was a resident company based in Bombay. Its entire shareholding belonged to two British companies—P. & O. Steam Navigation Co. Ltd. and British Indian Steam Navigation Co. Ltd., both non-resident entities engaged in shipping. Under a contractual agreement, Mazagaon Dock Ltd. repaired ships owned by these companies strictly at cost, without earning profits. The Income Tax Department invoked Section 42(2) of the Indian Income-Tax Act, 1922, arguing that due to the close connection between Mazagaon Dock Ltd. and the non-resident parent companies, the arrangement deprived the resident company of the profits it would ordinarily earn. Therefore, the department taxed Mazagaon Dock Ltd. on notional profits, computed as Rs. 6,80,000, Rs. 4,67,559, and Rs. 4,68,963 for different assessment years.
D) FACTS OF THE CASE
Mazagaon Dock Ltd. had its registered office in Bombay and qualified as a resident company for tax purposes in India. However, its entire share capital was held by two foreign corporations involved in shipping operations. According to their special agreement, the foreign companies sent their ships exclusively to Mazagaon Dock Ltd. for repairs. The repairs were performed at cost, resulting in zero profits for Mazagaon Dock Ltd. from these transactions. The Income-Tax Officer, upon examining the arrangement, determined that Mazagaon Dock Ltd. deliberately arranged its business with its parent companies to generate no profits, thus invoking Section 42(2). The tax authority computed the notional profits the company would have earned under arm’s length conditions and assessed tax accordingly.
The Appellate Assistant Commissioner upheld the Income Tax Officer’s assessment. However, the Income Tax Appellate Tribunal, presided by its President after an initial deadlock, reversed the order, ruling that Section 42(2) was inapplicable. Upon reference to the Bombay High Court, the High Court overturned the Tribunal’s decision, favoring the tax department. The matter reached the Supreme Court on special leave.
E) LEGAL ISSUES RAISED
i) Whether Section 42(2) of the Indian Income-Tax Act, 1922, imposes tax liability on the resident’s business or the non-resident’s business.
ii) Whether the arrangement between Mazagaon Dock Ltd. and its non-resident shareholders constituted “carrying on business with” under Section 42(2).
iii) Whether notional profits could be assessed and taxed in absence of actual profits.
iv) Whether tax could be imposed in the name of the resident when no real profits accrued.
F) PETITIONER/ APPELLANT’S ARGUMENTS
i) The counsels for Petitioner / Appellant submitted that:
Mazagaon Dock Ltd., represented by eminent counsel N.A. Palkhivala, argued that Section 42(2) could not apply because it intended to tax the non-resident’s business income derived from Indian sources, not the resident’s business. They contended that the term “profits derived” referred exclusively to actual profits earned by the non-resident. Since the resident earned no profits, no taxable event occurred. They emphasized that if any real income had been generated, it would automatically fall under the ordinary provisions of the Income-Tax Act, not Section 42(2).
They further asserted that their arrangement lacked the mutuality of business engagement envisaged under Section 42(2). The non-resident companies merely availed ship repair services, akin to any other customer, which did not amount to “carrying on business with” Mazagaon Dock Ltd. They argued that mere procurement of services could not establish a business connection or joint venture contemplated by Section 42(2).
They contended that invoking the deeming fiction under Section 42(2) was inappropriate, as the resident company was already the taxpayer, and no fiction was necessary if actual profits existed. They also relied on Rule 33 and Rule 34 of Indian Income-Tax Rules, 1922, asserting that these rules required apportionment of actual profits of the non-resident companies, not deemed profits of the resident company.
G) RESPONDENT’S ARGUMENTS
i) The counsels for Respondent submitted that:
The respondent, represented by H.N. Sanyal, Additional Solicitor General of India, argued that Section 42(2) targeted situations where residents, due to close business connections with non-residents, manipulated their business to avoid earning ordinary profits. The provision allowed tax authorities to compute notional profits the resident would have earned under independent commercial dealings.
They asserted that the business being taxed under Section 42(2) was unequivocally that of the resident, not the non-resident, as indicated by the term “profits derived therefrom” and “produces to the resident.” The respondent emphasized that even if no profits accrued, the tax authority could assess profits deemed to have been earned under arm’s length dealings.
The respondent countered the argument regarding lack of business connection by stating that the regular, exclusive, and organized nature of transactions between the resident and non-resident entities demonstrated a clear “carrying on business with” relationship. The repairs were integral to the non-residents’ shipping business, which further supported the existence of business connection.
The respondent relied on precedents such as Narain Swadeshi Weaving Mills v. Commissioner of Excess Profits Tax [1955] 1 SCR 952 and Commissioners of Inland Revenue v. Incorporated Council of Law Reporting (1888) 3 TC 105, which broadly interpreted the terms “business” and “profits” in tax statutes.
H) RELATED LEGAL PROVISIONS
i) Section 42(2) of the Indian Income-Tax Act, 1922
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ii) Indian Income-Tax Rules, 1922 – Rules 33 and 34
iii) Article 136 of the Constitution of India
I) JUDGEMENT
a. RATIO DECIDENDI
i) The Supreme Court held that Section 42(2) taxes the resident company on its own business, not the business of the non-resident entities. The Court highlighted that the words “profits derived therefrom” refer to profits from the resident’s business. Even if no actual profits were earned, the statute permitted taxation on profits reasonably deemed to have been derived.
ii) The Court emphasized that “carrying on business with” includes any organized, continuous commercial engagement. The exclusive repair services provided to non-resident companies under a special agreement constituted business activity with those entities.
iii) The Court rejected the argument that a purchase or service contract could not establish a business connection. The special and continuous nature of these transactions went beyond mere customer-service relations and qualified as a concerted business arrangement.
iv) The Court also dismissed the argument that tax under Section 42(2) imposed vicarious liability. The liability fell directly on the resident because the section taxes the resident’s suppressed business profits.
b. OBITER DICTA
i) The Court noted that tax statutes must be interpreted broadly when defining “business”. Even where the resident entity has made no profits due to its special relationship with the non-resident, tax authorities may reconstruct profits under Section 42(2).
ii) The Court clarified that statutory language in tax law sometimes creates artificial legal fictions necessary to prevent tax avoidance through business arrangements between related entities.
c. GUIDELINES
The judgment did not lay down general guidelines but clarified important principles:
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Section 42(2) targets resident entities who, due to close association with non-residents, suppress profits.
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Business between related parties must be assessed as if conducted on arm’s length principles.
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Courts will interpret “carrying on business with” broadly to include any continuous, organized commercial dealings.
J) REFERENCES
a. Important Cases Referred
i) Narain Swadeshi Weaving Mills v. Commissioner of Excess Profits Tax, [1955] 1 SCR 952
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ii) Commissioners of Inland Revenue v. Incorporated Council of Law Reporting (1888) 3 TC 105
iii) Commissioner of Income-Tax v. Currimbhoy Ebrahim & Sons, [1935] 3 ITR 395 (PC)
iv) Anglo-French Textile Co. Ltd. v. Commissioner of Income-Tax, [1953] SCR 454
v) Bangalore Woollen, Cotton and Silk Mills Co. Ltd. v. Commissioner of Income-Tax, Madras, [1950] 18 ITR 423
vi) Smith Barry v. Gordy (1946) 28 TC 250
vii) Tennant v. Smith, [1892] 3 Tax Cases 158
viii) In Re Major John, [1938] 6 ITR 434
b. Important Statutes Referred
i) Indian Income-Tax Act, 1922 – Section 42(2)
ii) Indian Income-Tax Rules, 1922 – Rules 33 and 34
iii) The Constitution of India – Article 136
