TMI Blog1976 (7) TMI 31X X X X Extracts X X X X X X X X Extracts X X X X ..... ssessee which is a public limited company claimed in the assessment proceeding under the Super Profits Tax Act, 1963, two items as being includible in the computation of its capital under the Second Schedule of the Act, viz., (i) provision for taxation : Rs. 22,75,000, and (ii) proposed dividend : Rs. 11,83,050. In regard to the first item, being provision for taxes in the sum of Rs. 22,75,000, the Income-tax Officer held that it could not be said to be a " reserve " within the meaning of rule 1 of the Second Schedule to the Super Profits Tax Act, 1963, and in that behalf reliance was placed by him upon the decision of the Supreme Court in the case of Kesoram Industries and Cotton Mills Ltd. v. Commissioner of Wealth-tax [1966] 59 ITR 767 (SC). He, accordingly, excluded the item from the capital computation. Similarly, in regard to the other item of proposed dividends in the sum of Rs. 11,83,050, he excluded the same from the capital computation on the ground that it represented an amount which had been set aside to meet a known and immediate liability to be discharged towards the shareholders and it could not, therefore, be a " reserve ". Feeling aggrieved by this order of the Inc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... andard deduction ", at the rate or rates specified in the Third Schedule. Section 2(5) defines the expression " chargeable profits " to mean the total income of an assessee computed under the Income-tax Act, 1961, for any previous year and adjusted in accordance with the provisions of the First Schedule, while section 2(9) defines the expression " standard deduction " to mean an amount equal to six per cent. of the capital of the company as computed in accordance with the provisions of the Second Schedule, or an amount of fifty thousand rupees, whichever is greater. In order to determine "standard deduction" it becomes necessary to compute the capital of the company in accordance with the rules laid down in the Second Schedule and rule 1 is relevant for our purposes, the material portion whereof runs as follows : " 1. Subject to the other provisions contained in this Schedule, the capital of a company shall be the sum of the amounts, as on the first day of the previous year relevant to the assessment year, of its paid up share capital and of its reserve, if any, created under the proviso (b) to clause (vib) of sub-section (2) of section 10 of the Indian Income-tax Act, 1922, or u ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s indicated by the profit and loss account a sum of Rs. 22,75,000 had been set apart for the purpose of taxation and, therefore, the provision for taxation of Rs. 22,75,000 made in the instant case by the board of directors should be regarded as a reserve within the meaning of rule 1 of the Second Schedule to the Super Profits Tax Act, 1963. It is not possible to accept this contention of Mr. Dwarkadas for the reasons which we shall presently indicate. It is true that the expression " reserve " has nowhere been defined in the Super Profits Tax Act, 1963, but it cannot be disputed that there is a clear-cut distinction between a provision and a reserve Schedule VI of the Companies Act, 1956, in Part I thereof sets out the form of balance-sheet and its contents which the company is required to prepare and Part II thereof sets out the form of profit and loss account and its requirements and Part III is the interpretation clause setting out the definitions of various expressions, of course, for the purpose of Part I and Part II of the said Schedule. Both the expressions " provision " and " reserve " have been defined in Part III. Clause 7(1)(a) of Part III defines the expression " pro ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ut of profits and other surpluses to provide for any known liability of which the amount cannot be determined with substantial accuracy is a provision : (See William Pickles Accountancy, second edition, page 192 ; Part III, clause 7, Schedule VI to the Companies Act, 1956, which defines provision and reserve)." It will thus appear clear that where an amount is set aside out of profits and other surpluses to provide for any known liability of which the amount cannot be determined with substantial accuracy, the same is a provision, but if the amount so set aside is not designed to meet a liability, contingency, commitment or diminution in value of assets known to exist at the date of balance-sheet, it will be a reserve. If the test as indicated above is applied to the item of Rs. 22,75,000 being the provision for taxation, it will be clear that this setting aside of the amount from out of the gross profits of the company will have to be regarded as a provision and not a reserve. It cannot be disputed that the relevant previous year in the instant case was the calendar year which ended on 31st December, 1962. Under rule 1 of the Second Schedule to the Super Profits Tax Act the firs ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... unting year and not a contingent liability. The rate was always easily ascertainable. If the Finance Act was passed, it was the rate fixed by that Act ; if the Finance Act was not yet passed, it was the rate proposed in the Finance Bill pending before Parliament or the rate in force in the preceding year, whichever was more favourable to the assessee. All the ingredients of a " debt " were present and that it was a present liability of an ascertainable amount and that, therefore, the amount of the provision for payment of income-tax and super tax in respect of the year of account ending 31st March, 1957, was a " debt owed " within the meaning of section 2(m) on the valuation date, viz., 31 st March, 1957, and was as such deductible in computing the net wealth. In the instant case also the liability to pay tax had arisen on the expiry of December 31, 1961, only its quantum had to be ascertained later and, therefore, the setting apart of the sum of Rs. 22,75,000 by the board of directors must be held to be a provision made by it to meet a known and existing liability. Having regard to the above discussion, we are clearly of the view that the taxing authorities as well as the Tribun ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... as merely a recommendation which might be modified or even withdrawn and, therefore, as on the crucial date nothing had happened beyond mere recommendation by the directors as to the amount that might be distributed as dividend ; in other words, according to him, the liability to pay dividend was to arise only when the shareholders at their general meeting would be passing the necessary resolution after accepting the recommendation of the board of directors. According to him, therefore, the appropriation or setting aside of this amount of Rs. 11,83,050 was not a provision but a reserve for it was not designed to meet any known or existing liability, contingency or commitment. In support of his contention he placed strong reliance upon the observations of the Supreme Court in Metal Box Co.'s case [1969] 73 ITR 53 (SC), where distinction between provision and reserve has been clearly indicated, and also upon the decision of the Supreme Court in Kesoram Industries' case [1966] 59 ITR 767(SC). He pointed out that for the purpose of the Wealth-tax Act one of the items which the Supreme Court was considering in that case was the item shown in the profit and loss account as the amount of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rofits of the assessee for purposes of income-tax. In February, 1946, the directors recommended that out of that amount a sum of Rs. 4,92,426 should be distributed as dividend and the balance of Rs. 16,211 was to be carried forward to the next year's account. This recommendation was accepted by the shareholders in their meeting on 3rd April, 1946, and the amount was shortly afterwards distributed as dividend. In computing the capital of the assessee-company on 1st April, 1946, under the Business Profits Tax Act, 1947, the assessee claimed that the sum of Rs. 5,08,637 and the profit earned by it during the period 1st January, 1946, to 1st April, 1946, should be treated as " reserves " for the purpose of rule 2(1) of Schedule II. The High Court held that the sum of Rs. 5,08,637 must be treated as a reserve for the purpose of rule 2, but the profit made by the assessee during the period 1st January, 1946, to 1st April, 1946, could not be included in the reserves. On appeal to the Supreme Court, the Supreme Court held that the sum of Rs. 5,08,637 and the profit earned by the assessee during the period 1st January, 1946, to 1st April, 1946, did not constitute reserves within the meaning ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t was up to the shareholders of the company to accept that recommendation in which case alone the distribution could take place and since the recommendation was accepted and the dividend was actually distributed, it would not be correct to say that the amount was kept back. The court further held that the nature of the amount which was nothing more than the undistributed profits of the company, remained unaltered, and, therefore, the profits lying unutilised and not specially set apart for any purpose on the crucial date did not constitute reserves within the meaning of Schedule II, rule 2(1). Support for this view was also sought by the Supreme Court by referring to the provisions of sections 131(a) and 132 of the Indian Companies Act, and the forms of balance-sheet and profit and loss account as given in Schedule III to the said Act. At this stage it would be convenient to refer to the decision of the Punjab and Haryana High Court in the case of Commissioner of Income-tax v. Hindustan Milk Food Mfg. Ltd. [1975] 98 ITR 517 (Punj), where Chief Justice Mahajan of the Punjab and Haryana High Court, after analysing the aforesaid decision of the Supreme Court in Century Mills' case [ ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ief Justice Mahajan has gone on to observe at page 525 of the report as follows [1975] 98 ITR 517, 525 (Punj) : " It will appear from the above observations that the following matters weighed with their Lordships in holding that the amount of Rs. 5,08,637 was not a reserve, namely : (1) that the said amount was simply brought from the profit and loss account to the next year and nobody with any authority on that date made or declared a reserve; (2) that the reserve could be a general reserve or a specific reserve, but there must be a clear indication to show that it is a reserve of one or the other kind ; (3) the mass of undistributed profits cannot automatically become a reserve ; (4) the mere recommendation by the directors that the amount be distributed as dividend did not show that the directors had made the amount in question a reserve. But it shows that they had decided to earmark it for distribution as dividend. If these matters are kept in view, it will appear that two things must co-exist before an amount can be treated as a reserve, namely, (a) that the amount must be separated from the general mass of profits, and (b) that it should be apparent from the surro ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... " undivided profit " or set apart as " earned surplus " in accordance with the system of accountancy which obtained in United States amounted to a reserve liable to be included in the capital computation under rule 2 of Schedule II of the Business Profits Tax Act, 1947. The decisions have an important bearing on the issue with which we are concerned, especially as the principle of general guidance as to the purpose for which such inclusion in the computation of capital is to be made under the Business Profits Tax Act has been indicated. In both the cases the court was concerned with the assessees who were non-resident companies and followed the system of accounting which obtained in the American commercial world. In the first mentioned case, Justice Kapur, speaking for the court, pointed out the difference between the two systems of accounting in these words---See [1961] 42 ITR 17, 23 (SC) : " In India at the end of an year of account the unallocated profit or loss is carried forward to the account of the next year, and such unallocated amount gets merged in the account of that year. In the system of accounting in the USA each year's account is self-contained and nothing is carri ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e Business Profits Tax Act. From these two decisions two aspects could be said to emerge very clearly. In the first place, the nomenclature accorded to any particular fund which is set apart from out of the profits would not be material or decisive of the matter and, secondly, having regard to the purpose of rule 2 of Schedule II of the Business Profits Tax Act, 1947, it was clear that if any amount set apart from out of the profits is going to make up capital fund of the assessee and would be available to the assessee for its business purpose, it would become a reserve liable to be included in the capital computation of the assessee for the purpose of the Business Profits Tax Act. Having regard to the above discussion two or three things become at once clear. In the first place, the mass of undistributed profits cannot automatically become a reserve and that somebody possessing the requisite authority must clearly indicate that the amount has been separated from the general mass of profit with a view to constitute it a reserve ; secondly, it should be apparent from the surrounding circumstances that the amount so set apart is in fact a reserve to be utilised in future for a spec ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... thak and H. N. Seth JJ. took a view that the provision for proposed dividend by a company was entitled to be treated as " reserves " for the purposes of rule 1 of the Second Schedule to the Super Profits Tax Act, 1963, and that the same should be included in the computation of capital under that provision where there was no dispute that the said items had actually been debited to the assessee's profit and loss account and had not been allowed as a deduction for the purpose of income-tax assessment. This decision was rendered on 9th August, 1971, and within a few months the same Bench in the case of Commissioner of Income-tax v. Hind Lamps Ltd. [1973] 90 ITR 487 (All) has taken exactly the contrary view. The court in that case was concerned with four items including the item of " proposed dividend " and after referring to the Supreme Court's decision in Century Mills' case [1953] 24 ITR 499 (SC) as well as two later decisions of the Supreme Court in First National City Bank's case [1961] 42 ITR 17 (SC) and Standard Vacuum Oil Co.'s case [1966] 59 ITR 685 (SC), held that the said four items including the item of proposed dividend cannot represent a reserve and cannot be included in t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ndicated clearly that the amounts had been earmarked, the one for payment of the dividend and the other for the discharge of a tax liability which had already accrued and merely awaited quantification by assessment. The qualitative difference in the material available in the latter case led to a decision different from that in the former case." It is unnecessary for us to dilate on this point any further. We may also mention that the Madras High Court in Nagammal Mills Ltd. v. Commissioner of Income-tax [1974] 94 ITR 387 (Mad) as also in United Nilgiri Tea Estates Co. Ltd. v. Commissioner of Income-tax [1974] 96 ITR 734 (Mad) and the Andhra Pradesh High Court in Vazir Sultan Tobacco Co. Ltd. v. Commissioner of Income-tax [1974] 96 ITR 248 (AP) have taken the view that the amount set apart for payment of " proposed dividends " to the shareholders cannot be regarded as a reserve within the meaning of that expression as occurring in rule 1 of Schedule II to the Super Profits Tax Act, 1963. Two or three decisions which were relied upon by Mr. Dwarkadas in support of his contention may now be referred to. Relying upon the distinction made between " provision " and " reserve " by t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... erent enactments and the points which arose for decision were entirely different from the point that has arisen before us under the Super Profits Tax Act, 1963. In the Metal Box Co.'s case [1969] 73 ITR 53 (SC) as well as in the case of Workmen of William Jacks and Co.'s case AIR 1971 SC 1821 the question had arisen under the Payment of Bonus Act, 1965, and the question was whether certain sums which had been set apart for payment of gratuity under the gratuity scheme could be legitimately debited in the profit and loss account and whether such appropriation amounted to a reserve or a provision and it was in that context that distinction between " provision " and " reserve " was made and the question was considered as to whether the appropriation for the estimated liability under the gratuity scheme, such as the one which the court had before it, was in respect of known and existing liability and as such was deductible from the gross receipts while preparing the profits and loss account. In Kesoram Industries' case [1966] 59 ITR 767 (SC) the question had arisen under the Wealth-tax Act and the question was whether the amount which had been set apart by the directors as an amount pr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f the issue then becomes dependent upon whether the sum set apart by the board of directors and recommended by the directors for dividend distribution is actually used for that purpose or not, for, according to him, it is open to the shareholders in their general meeting not only to modify the recommendation of the board of directors but even to reject it in which case the amount though recommended by the board of directors for payment of proposed dividends would form part of reserve which would be available to the assessee for business in future. It may be that different considerations may arise if such a situation occurs. But, in the instant case before us, no material has been placed before us to show that the recommendation of the board of directors had been modified or rejected by the shareholders in their general meeting. On the admitted facts which are available on record it seems to us clear that the directors as on the crucial date had not set apart the amount of Rs. 11,83,050 as and by way of any reserve to become available to the assessee-company for business in future but had in fact by their conduct set it apart avowedly for the purpose of payment of proposed dividends ..... X X X X Extracts X X X X X X X X Extracts X X X X
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