Who Owns Pre-Incorporation Profits?

The common sense view seems to be that, if a person (company) does not exist, anything done before the company's incorporation cannot bind it. Even after incorporation, such acts cannot be ratified by the company because it had no existence when the contracts were made. [See the Rajasthan High Court's decision in the case of Seth Sobhag Mal Lodha vs Edward Mills Co. Ltd (1972), 42 Com.Cas 1 (Raj).]

There have, however, been differences of opinion among the high courts on how and in whose hands the pre-incorporation profits and loss from business should be considered. The Allahabad High Court in CIT vs. Bijli Cotton Mills Ltd (1953) 23 ITR 278 (All.) has taken the view that, under the Income Tax Act, legal ownership apart, the court could also go into the question of beneficial ownership and decide who should be liable for tax after taking into account the question of who received the income.

 

The Calcutta High Court has taken a different view in CIT vs. Tea Producing Co. of India Ltd. (1963) 48 ITR 200 (Cal.). It has observed that it could not see how a person could be said to have carried on a business during a period when he was not born or how he could be assessable for tax.

The issue now stands resolved by the Supreme Court's decision in CIT vs. City Mills Distributors (P) Ltd (1996) 219 ITR 1 (SC). Affirming the Calcutta High Court's view the Supreme Court has said that the relevant question was: who was the legal entity that had carried on the business before the assessee company was incorporated and earned the income at the time of its accrual? Since the assessee company did not exist when the income concerned was earned, it is, therefore, not liable to pay tax on it.

The same result is reached by a different process of reasoning. A company can enter into an agreement only after its incorporation. It is only after incorporation that a company may decide to accept that its promoters have carried on business on its behalf and appropriate the income to itself. The question of who is liable to tax on such income cannot depend upon whether or not the company decides to do so after its incorporation. It is he who carried on the business and received the income when it accrued who is liable to bear the burden of tax for it.

The legal position that stands confirmed now is that promoters will have to be held responsible for profit or loss for the pre-incorporation period irrespective of whether the company accepts such transactions after incorporation. However, in this decision, the Supreme Court has made no reference to appropriation of profit into pre-incorporation and post-incorporation periods where the accounts continued to be one. Hence, where no appropriation has been made or cannot be made and therefore the whole profit should be taxed in the company's hands continues to be moot point.

However, under the Indian Specific Relief Act, 1963, pre-incorporation contracts can be enforced against a company.