TMI Blog1976 (6) TMI 28X X X X Extracts X X X X X X X X Extracts X X X X ..... evious year being the calendar year ended December 31, 1962. The assessee-company was after the relevant dates amalgamated with Messrs. M. G. Investment Corporation Limited, Bombay, but, for the purpose of this reference, it will be referred to as 'the assessee company'. It was a public limited company. For the calendar year ending on December 31, 1961, it earned a net profit of Rs. 7,15,115. As of January 1, 1961, an amount of Rs. 10,488, had been carried forward from the profit and loss account for the calendar year ending on December 31, 1960. The total disposable amount thus came to Rs. 7,25,603. Out of this aggregate amount, the assessee-company by a resolution of its board of directors transferred a sum of Rs, 3,26,000 to " taxation provision ", a sum of Rs. 2,13,600 to " proposed dividend " account and an amount of Rs. 1,50,000 to " general reserve " account. The balance of Rs, 36,003 was carried forward to the next year. The resolution of the board of directors of the assessee-company appears to have been passed on April 23, 1962, and by the directors' report dated April 23, 1962, the directors recommended that a provision for taxation should be made in the amount of Rs. 3, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... cific purpose of parting with it after a short time and was never to be received back and the Super Profits Tax Officer pointed out that this amount of Rs. 2,13,600 had actually been distributed by the assessee company amongst the shareholders. As regards the company's claim regarding the sum of Rs. 3,31,069 which was set apart as taxation provision, the contention was rejected by the Super Profits Tax Officer on the ground that the amount was set apart for anticipated liability and the money was an outgoing after a short period in the commercial sense of the word and that the said fund was not likely to be retained in the business for any of the purposes for which reserves are created. The assessee-company carried the matter in appeal and the Appellate Assistant Commissioner rejected the contention of the assessee-company regarding the sum of Rs. 3,31,069 on the ground that this amount was kept aside by way of provision for taxation which was clearly distinguishable from reserve. He held that the taxation provision was a charge against profits while a reserve was a portion of the profit normally available for distribution to the shareholders of the company and was not charged agai ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ore, we will first refer to the salient features of the Act of 1947. It may be pointed out that the Act of 1947 applied to all assessees like a firm, a Hindu undivided family and a limited company. Section 4 was the charging section and under that section, subject to the provisions of the Act, in respect of any business to which the Act applied, was to be charged, levied and paid on the amount of the taxable profits during any chargeable accounting period, a tax which was referred to in the Act as " business profits tax " which was to be equal to sixteen and two-thirds per cent. of the taxable profits, for any chargeable accounting period ending on or before the 31st day of March, 1947, and in respect of any chargeable accounting period beginning after 31st day of March, 1947, be equal to any such percentage of the taxable profits as might be fixed by the annual Finance Act. Under section 5 that Act was to apply to every business of which any part of the profits made during the chargeable accounting period was chargeable to income-tax by virtue of the provisions of sub-clause (ii) of clause (b) of sub-section (1) of section 4 of the Indian Income-tax Act, 1922, or of clause (c) o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s investments or other property the income from which was not includible in the profits, so far as that cost exceeded any debt for money borrowed by it. In all other cases, the capital was to be the sum ascertained in accordance with sub- rule (1), diminished by the cost to the company of its investments so far as that cost exceeded any debt for money borrowed by it. Explanation to sub-rule (2) stated that a reserve or paid-up share capital brought into existence by creating or increasing (by revaluation or otherwise) any book asset was not capital for the purposes of ascertaining the abatement under the Act in respect of any chargeable accounting period. Thus, under the scheme of rule 2 of Schedule 11 of the Act of 1947, the amount of the paid up share capital and the amount of its reserve were to be calculated and the amount of reserves was to be the amount in so far as the same had not been allowed in computing the profits of the company for the purposes of the Indian Income-tax Act. We are not concerned with the rest of the provisions of that rule. The paid up share capital plus the reserves as mentioned in the above sub-rule were to be the amount on the basis of which the abat ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sions contained in the 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 under sub-section (3) of section 34 of the Income-tax Act, 1961, and of its other reserves in so far as the amounts credited to such other reserves have not been allowed in computing its profits for the purposes of the Indian Income-tax Act, 1922, or the Income-tax Act, 1961, diminished by the amount by which the cost to it of the assets the income from which in accordance with clause (iii) or clause (vi) or clause (viii) of rule 1 of the First Schedule is not includible in its chargeable profits, exceeds the aggregate of any money borrowed by it which remains outstanding, and the amount of any fund, any surplus and any such reserve as is not to be taken into account in computing the capital under the rule. This is the material provision in so far as the facts of the present case are concerned. We are concerned with the words " its other reserves ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... as exceed the statutory deduction, at the rate or rates specified in the Third Schedule. The Second Schedule, as under the scheme of the Acts of 1947 and 1963, sets out the rules for computing the capital of a company for the purpose of surtax. Under rule 1 of the Second Schedule, subject to the other provisions contained in the Schedule, the capital of a company shall be the aggregate of the amounts, as on the first day of the previous year relevant to the assessment year, of-- (i) its paid-up share capital ; (ii) its reserves, 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 under sub-section (3) of section 34 of the Income-tax Act, 1961 ; (iii) its other reserves as reduced by the amounts credited to such reserves as have been allowed as a deduction in computing the income of the company for the purposes of the Indian Income-tax Act, 1922, or the Income-tax Act, 1961 ; (iv) its debentures, if any ; and (v) any moneys borrowed by it from Government or the Industrial Finance Corporation of India or the Industrial Credit and Investment Corporation of India or any other financial institution which ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ecide the total figure of capital and reserves for computation of the capital. The previous year of the assessee before us was the calendar year 1962 and it is, therefore, obvious that the paid up capital and reserves as at the commencement of the previous year, namely, calendar year 1962, would be what is shown in the balance-sheet of the company as of 31st December, 1961, because what is shown in the balance-sheet as of December 31, 1961, would be the opening amounts of paid up capital and reserves as of January 1, 1962. In Commissioner of Income-tax v. Century Spg. and Mfg. Co. Ltd. [1953] 24 ITR 499; 23 Comp Cas 462 (SC), the Supreme Court was concerned with the provisions of the Act of 1947, and the facts of the case were as follows. For the year ending December 31, 1945, the profit of the assessee-company, whose accounting year was the calendar year, was a certain sum according to the profit and loss account. After making provision for depreciation and taxation, the balance of Rs. 5,08,637 was carried to the balance-sheet. This sum was not allowed in computing the profits of the assessee for purposes of income-tax. In February, 1946, the directors recommended that out of th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of Rs. 5,08,637 could not be called a reserve for nobody possessed of the requisite authority had indicated on that date the manner of its disposal or destination. On the other hand, on the 28th February, 1946, the directors clearly earmarked it for distribution as dividend and did not choose to make it a reserve. Nor did the company in its meeting on the 3rd April, 1946, decide that it was a reserve. It remained on the 1st of April as a mass of undistributed profits which were available for distribution and not earmarked as 'reserve'. On the 1st of January, 1946, the 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. The reserve may be a general reserve or a specific reserve, but there must be a clear indication to show whether it was a reserve either of the one or the other kind. " It was pointed out by the Supreme Court in this case that on April 1, 1946, which was the commencement of the chargeable accounting period, there was merely a recommendation by the directors that the amount in question should be distributed as dividend. Far from showing that the directors had made the amou ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... at is the true nature of a reserve shown in a balance-sheet. In First National City Bank v. Commissioner of Income-tax [1961] 42 ITR 17 (SC) the question once again arose before the Supreme Court regarding the question of reserves under the Act of 1947. The assessee in that case was a non-resident bank incorporated under the National Bank Act of the United States of America and it was following the system of accounting adopted by American banks. This system conformed to the instructions contained in the Treasury Rules of the USA and under those rules the assessee set aside and transferred the net profits of each year, after provision for expenses, taxes, dividends and reserves, to an account headed " undivided profits ". The statute under which an allocation had to be made under that account treated " undivided profits " as part of the capital funds of the bank. By his letter the Deputy Controller of Currency, Washington, affirmed that in the USA the " undivided profits " actually represented a part of the capital funds of the bank and was included to ascertain the adequacy of capital of the bank. When losses occurred it was the usual practice in many banks to charge them against ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ear'....... As it is the use or employment of capital in banking, not mere possession thereof by the banker, which determines the amount of tax, the fact that a portion of the capital so used or employed is designated ' undivided profits ' is of no legal significance. " The Supreme Court of India in the case of First National City Bank [1961] 42 ITR 17 (SC) pointed out that the term " undivided profits " simply followed a bank accounting nomenclature used in the United States to designate profits set aside, after provisions for expenses and taxes, dividend, and reserves, for continuous future use in the business of the bank and it bore a close, if not identical, relationship to the earned surplus account of an industrial corporation. The Supreme Court further pointed out that the creation and maintenance of the item known as " undivided profits " was at requirement of the Treasury rules which were made under the Statute and, therefore, it could not be said that the amount of undivided profits in the balance-sheet was not allocated as a result of either a resolution of the directors, accepted by the shareholders or on account of the requirements of the law. The Supreme Court in th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of $100 each and to Socony Vacuum Oil Company serial bonds of the value of $13,093,300. The remaining ten shares of the share capital of the assessee-company were divided equally between the two companies for cash. The assessee-company entered in its books of account the book value of the assets taken over from the companies and the excess of the net value of the assets transferred over the par value of the stock issued and the serial bonds was entered in the account styled " capital paid in surplus ". Later, the serial bonds issued to the Socony Vacuum Oil Company were redeemed. After some adjustments the " capital paid in surplus " account was reduced to $117,561,317 and thereafter stood unchanged at that figure. The net profits earned by the company year after year, subject to certain appropriations, were shown in the balance-sheet under the caption " earned surplus ". The balance of " earned surplus " was $29,557,597 at the end of 1945. It progressively increased thereafter and, by the end of 1948, stood at $73,766,592. The questions were, (i) whether the " capital paid in surplus " was a premium realised from the issue of shares within the meaning of rule 3 of Schedule II to t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s he then was, delivering the judgment of the Supreme Court, pointed out that it was not necessary that the reserve should be built up out of profits. It was laid down that the reserves which were not built out of profits could not be excluded from the operation of rule 2(1). As regards " earned surplus ", it was observed by the Supreme Court that that amount had not been called " reserve " but if it was truly a reserve, it must be taken into account in the computation of capital. In considering this question, it was necessary to note certain special features of the system of accounting obtaining in the United States of America. It was pointed out that by setting apart funds as " earned surplus " it was intended to designate a fund which was to be utilised for the purpose of the business of the assessee. Such a fund may be regarded according to the Indian practice as " general reserves ". After referring to the decision of the Supreme Court in Century Spg. Mfg. Company's case [1953] 24 ITR 499 (SC), Shah J. observed at page 697 of [1966] 59 ITR 685 (SC) : " The court was dealing in that case with the accounts of an Indian company, the balance-sheet of which was prepared accordi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... On these facts, the Supreme Court, rejecting the contention of the department, held that the determination of the directors to appropriate the amounts to the three items of reserve on August 8, 1963, had to be related to April 1, 1963, viz., the beginning of the accounts for the new year, and had to be treated as effective from that day. The three items had to be added to other items for the computation of the capital of the respondent as on April 1, 1963, under rule 1 of Schedule II of the Act of 1964. At page 569 of the report, Mitter J., delivering the judgment of the Supreme Court, observed : " The sole contention on behalf of the appellant is that these appropriations having been made on the 8th August, 1963, could not be treated as components of capital 'as on the first day of the previous year', i.e., the first of April, 1963, in terms of rule 1 to the Second Schedule. The learned Solicitor-General submitted that these could only be taken into consideration in the subsequent year commencing on the 1st of April, 1964, on the ground that on the 1st of April, 1963, they only formed a part of the mass of undistributed profits, no portion of which had been earmarked or set apar ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of the year ended 31st December, 1948, the amounts mentioned were shown respectively in the reserve fund and the dividend reserve fund and the shareholders, by passing a resolution on 27th June, 1949, did not decide that these amounts should constitute reserves as from that date but they accepted the recommendation of the directors that these amounts should constitute reserves as of 31st December, 1948. In our opinion, the approval of the Supreme Court to the decision of the Bombay High Court in Aryodaya Ginning and Manufacturing Co. Ltd.'s case [1957] 31 ITR 145 (Bom) and disapproval of the decision of the Madras High Court in Vasantha Mills Ltd.'s case [1957] 32 ITR 237 (Mad) is very significant and important. In Commissioner of Income-tax v. Aryodaya Ginning and Mfg. Co. Ltd. [1957] 31 ITR 145 (Bom) the limited company made up its accounts at the end of December every year. For the year ending December 31, 1948, the directors made certain appropriations of the profits of that year and the profits brought forward from the previous year, and allocated certain amounts to the reserve fund and the dividend reserve fund. At a general meeting held on June 27, 1949, the shareholders ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y the Supreme Court and the Supreme Court held that nobody possessed of the requisite authority had indicated on that date the manner of its disposal or destination and the fact that that amount constituted a mass of undistributed profits could not automatically make it a reserve. Therefore, it will be noticed that in the case before the Supreme Court there was no reserve at all and therefore no question arose as to when the reserve could be considered as having been constituted ......... In the case before us we have this distinguishing feature that certain amounts have been earmarked by the directors as reserve, and the shareholders have accepted the recommendation and passed a resolution at the general meeting. On principle, too, the contention put forward by the Commisioner seems to us to be untenable. The business profits tax gives to a businessman certain abatement in respect of capital utilised by the company, it also gives abatement in respect of reserves because reserves are looked upon as standing on the same footing as capital. If that be the principle underlying taxation under the business profits tax, then it is difficult to understand why a businessman should not ge ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Bank of Bihar Ltd. [1953] 24 ITR 9 (Pat), the Patna High Court was concerned with the Act of 1947 and in that case the Patna High Court dissented from the view of the Bombay High Court in Commissioner of Income-tax v. Century Spinning and Manufacturing Co. Ltd. [1951] 20 ITR 260 (Bom). As pointed out earlier, the Supreme Court reversed the decision of the Bombay High Court in Commissioner of Income-tax v. Century Spinning and Manufacturing Co. Ltd. [1953] 24 ITR 499 (SC). The decision of the Patna High Court proceeded upon the footing that unless the directors apply their mind to the question and unless they make appropriations of the balance to the payment of dividends or to building up reserves it cannot be said that any portion of the amount of balance in the profit and loss account can be treated as " reserve or reserves " for the purpose of computing the amount of capital under rule 2 of Schedule II of the Act of 1947. In Indian Steel Wire Products Ltd. v. Commissioner of Income-tax [1955] 27 ITR 436 (Cal), the Calcutta High Court was concerned with the Act of 1947. It followed the Supreme Court decision in Century Spinning and Manufacturing Co. Ltd.'s case [1953] 24 ITR 4 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... paid (shown on the debit side of the balance-sheet). The amounts of advance tax paid should not, in any event, be deducted from the " taxation reserve fund ". A reserve is created only out of the whole or a part of the surplus profits as they are found to be in the hands of the company at the end of the year, and advance payments of tax under section 18A of the Income-tax Act are payments on account and cannot be treated as part of the reserve for the purpose of the Business Profits Tax Act. Thus, this decision stands on practically the same lines as the decision in Indian Steel and Wire Products Ltd. v. Commissioner of Income-tax [1958] 33 ITR 579 (Cal), which was also referred to by this High Court. In Aluminium Industries Ltd. v.Commissioner of Income-tax [1968] 68 ITR 125 (Ker) the Kerala High Court was concerned with the Act of 1963, and following the observations of the Supreme Court in Century Spinning and Manufacturing Co. Ltd.'s case [1953] 24 ITR 499 (SC) and in Standard Vacuum Oil Company's case [1966] 59 ITR 685 (SC) as well as in First National City Bank's case [1961] 42 ITR 17 (SC), it was held that a reserve may be a general reserve or a specific reserve, but in or ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... reserve ", the amount must be specifically kept apart for future use or for a specific occasion, it held that the amounts of proposed dividends, provision for taxation, credit balance of profit and loss account and depreciation reserve, being excess of book depreciation over income-tax allowed depreciation, could not be considered as representing " reserves " and none of these four items could be said to represent " reserves" for the purpose of computation of capital under the Act of 1963. The Allahabad High Court held that none of the first three items which were under consideration before it was set apart as a reserve for any purpose and those three items fell within the rule laid down in the Century Spinning and Manufacturing Co. Ltd.'s case [1953] 24 ITR 499 (SC). The fourth item, which was described as depreciation reserve was the excess of book depreciation over the income-tax allowed depreciation. There was no evidence that the amount was set apart for a future use, and, having regard to the test laid down by the Supreme Court in the decisions cited, it could not be treated as a reserve. In Commissioner of Income-tax v. British India Corporation (P.) Ltd. [1973] 92 ITR 38 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ills Co. Ltd. v. Commissioner of Wealth-tax [1967] 63 ITR 470 (SC). It is true that the Supreme Court in that case was concerned with the Wealth-tax Act and particularly sections 2(m) and 7(2). In that case the Supreme Court held that the liability of the assessee to pay gratuity to its employees on determination of employment was a mere contingent liability which arose only when the employment of the employee was determined by death, incapacity, retirement or resignation ; the liability did not exist in praesenti. The amount claimed could not be deducted as a " debt " in computing the net wealth of the assessee. Nor could such a contingent liability be taken into account in computing the net value of the assets of the assessee under section 7(2)(a) of the Wealth-tax Act, 1957. However, in view of the clear distinction made by the Supreme Court in Metal Box Company of India Ltd. v. Their Workmen [1969] 73 ITR 53 ; 39 Comp Cas 410 (SC), between a provision and a reserve as known to accountancy practice, it must be held that in the light of the Standard Mills Co. Ltd.'s case [1967] 63 ITR 470 (SC) funds set apart for payment of gratuity to the workers will form part of the reserves ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tuity, a contingent and future liability, and which have been used for the purpose of the business of the company, should be treated as a " reserve " within the meaning of rule 1 of the Second Schedule to the Act of 1963, in determining the " standard deduction " to which a company is entitled and such reserve need not be a capitalised or tied up reserve. Similarly, the excess provision for taxation which was available for use by the company in its business is a reserve with the meaning of the Act. It is true, as pointed out by Hegde J., speaking for the Supreme Court in Bombay Dyeing and Manufacturing Co. Ltd. v. Commissioner of Wealth-tax [1974] 93 ITR 603 (SC) at page 604, the decision in Metal Box Company's case [1969] 73 ITR 53 (SC) was a decision rendered under the Payment of Bonus Act. However, we are referring to that judgment for the purpose of pointing out what the standard commercial accountancy practice is in connection with reserves and provisions and the distinction between provision and reserve according to the standard commercial accountancy practice as recognised by the Supreme Court in this connection. As observed earlier, according to the Supreme Court in Commi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... heet under the heading ' Notes' at the end of that part. " When one turns to Schedule VI of the Companies Act, one finds in Part I the form of balance-sheet. In the balance-sheet " Current liabilities and provisions " are separately mentioned. Item No. (4) under the heading " Current liabilities and provisions " is " Advance payments and unexpired discounts for the portion for which value has still to be given " and item No. (8) under the head " Current liabilities and provisions " is " Provision for taxa- tion " and item No. (9) is " Proposed dividends ". The learned Advocate-General appearing on behalf of the revenue has laid considerable stress on this form of the balance-sheet which is statutorily prescribed. Part III of the Schedule VI deals with " Interpretation " and under rule 7 set out in Part III, clause (a) : " For the purposes of Parts I and II of this Schedule, unless the context otherwise requires,-- (a) the expression ' provision' shall, subject to sub-clause (2) of this clause, mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... priations out of the profits whereas provisions are charges against profits. At page 188, Pickles has pointed out that : " Where there is a possibility that upon the happening of a contingency an actual liability will arise, it is not usual to make any relevant provision in the accounts, but by way of a footnote to the balance-sheet. " " If the contingency does arise it will involve a loss. The liability incurred may be reflected in an asset, e.g., the call on the share may arise because the company is in difficulties, in which case the liability incurred will probably be considered a loss. " As is very clear from the decisions of the Supreme Court particularly in Standard Vacuum Oil Company's case [1966] 59 ITR 685 (SC) and First National City Bank's case [1961] 42 ITR 17 (SC), the standard textbooks on accountancy have also to be taken into account. When the matter was being argued before us it was state at the Bar by Mr. Kaji appearing on behalf of the assessee that the provision of Rs. 3,26,000 in the accounts for calendar year 1961, which was by way of " taxation provision " was for the tax liability on profits earned in 1961 and it was urged by the learned Advocate-Ge ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed to follow have also to be borne in mind. It is because of this account-keeping practice that the statute imposes upon the assessee-company under the Indian Companies Act, 1956, particularly the form of the balance sheet, that this distinction between " provision " and " reserve " also becomes material for the purpose of finding out what exactly constitutes "reserve" under rule 1 of Schedule II to the Act of 1963. It is true that though the Indian Companies Act was in force when the Act of 1963 was enacted, there is no reference in the definition section to the Companies Act, 1956, but in view of the decision of the Supreme Court in Standard Vacuum Oil Company's case [1966] 59 ITR 685 (SC), it is really not necessary that there should have been any such reference in the definition section because the requirement of the statute which the company is required to follow in its account-keeping practice have to be taken into consideration while considering this question of reserve. In the Guide to Company Audit, third edition, 1972, published by the Research Committee of the Institute of Chartered Accountants of India, at page 70, the treatment in accounts of liability for taxation a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e amount in respect of which should be specified. " It is true, as Mr. Kaji has contended, in the light of the decisions of the Supreme Court discussed above, that it is the substance and not the form that matters and if there is no existing liability as at the date of the balance-sheet, that is, December 31, 1961, in the instant case, the amount set apart for the dividend cannot be said to be an amount set apart for meeting a present liability. Though, therefore, under the Companies Act, the proposed dividend has to be shown under the heading " provisions ", in substance, it amounts to a " reserve " as known to accountancy practice which has been approved by the Supreme Court in the Metal Box Company of India Ltd.'s case [1969] 73 ITR 53 (SC). Under these circumstances we must hold that the amount of Rs. 2,13,600 standing in the proposed dividend accounts as on December 31, 1961, was includible in computing the capital of the company but the amount of Rs. 3,31,069 standing in the " provision for taxation account " as on December 31, 1961, was not includible in computing the capital of the company. Under these circumstances, we answer question No. 1 in the negative, that is, in ..... X X X X Extracts X X X X X X X X Extracts X X X X
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