TMI Blog1965 (10) TMI 24X X X X Extracts X X X X X X X X Extracts X X X X ..... Held that:- The assets received by the assessee-company are real and tangible assets. It is only for accountancy purposes that a part of the value of the assets is allocated to the par value of the shares and the balance to the " Capital Surplus brought in " account. The High Court was, therefore, right in holding that the account " Capital Surplus brought in " in the balance-sheet represents premium realised from the issue of its shares within the meaning of rule 3, or in the alternative represents reserves not allowed in computing the profits of the company for the purpose of the Indian Income-tax Act, 1922. The High Court was therefore right in holding that the " earned surplus " represented reserves. The method in which the accounts are maintained in the light of the accountancy practice clearly indicates that, at the end of each year, there have been specific appropriations in tne account, and the conditions which this court regarded as essential in Century Spinning & Manufacturing Company's case for constituting the fund into reserve are fulfilled. Appeal dismissed. - - - - - Dated:- 26-10-1965 - Judge(s) : K. SUBBA RAO., J. C. SHAH., S. M. SIKRI JUDGMENT The ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 000. The remaining ten shares were divided equally between the two transferor companies for cash at par value. The assessee-company entered in its books of account the book value of the assets taken over from the transferor companies. The excess of the net value of the assets so transferred over the par value of the stock issued and the serial bonds was entered in the books in an account styled " Capital paid in Surplus." The serial bonds issued to the Socony Vacuum Oil Company were later redeemed. By adjustment entries the " Capital paid in Surplus " account was reduced to $ 117,561,317 and throughout the period of three years to which these appeals relate, in the balance-sheets of the assessee-company, the " Capital paid in Surplus " 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 " or " earnings reinvested. " At the end of 1945, the balance of " earned surplus " was $ 29,557,597 and by the end of 1948 the account stood at $ 73,766,592. The Income-tax Officer disallowed the claim of the assessee-company for inclusion of the account " Capit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f its paid-up share capital and of its reserves in so far as they have not been allowed in computing the profits of the company for the purposes of the Indian Income-tax Act, 1922 (XI of 1922), diminished by the cost to it of its investments or other property the income from which is not includible in the profits, so far as that cost exceeds any debt for money borrowed by it ... Explanation.--- A reserve or paid-up share capital brought into existence by creating or increasing (by re-valuation or otherwise) any book asset is not capital for the purposes of ascertaining the abatement under this Act in respect of any chargeable accounting period. 3. So much of the premium realised by a company from the issue of any of its shares as is retained in the business shall be regarded as forming part of its paid-up capital for the purposes of rule 2. " The first two questions referred by the Tribunal relate to the true nature of the amount entered in the books of account of the assessee-company under the caption " Capital paid in Surplus ". It is a common practice in the United States of America in transactions in which business assets are transferred to a new company, to issue shar ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... er method of handling, in the accounts, the item of no par value stock is to set up on the books, as a charge against capital, the amount of the consideration received for each issue of such stock and that any other increases or any decreases in net assets should be carried on the balance-sheet under the headings of Surplus and Deficit, just as if the capital charge had been made in connection with the issuance of stocks having a par value. They will therefore keep the capital stock entry a constant figure, representing the amount of consideration received for the same, and, if the corporation earns money, they will set up, on the liabilities side of the balance-sheet an item which they call ' surplus ' or ' undivided profits ' ... If additional no par value stock is issued, although, under the theory of no par value stock, it need not be issued at the same price as the original issue but at such price as the directors determine to be for the best interests of the corporation, the number of shares issued will be added to the number of shares outstanding and the consideration received for the same will be added to the figures opposite the entry ' capital stock ', and thereafter the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... plicants for shares. But that is not because the law contains any prohibition against charging differential premiums. The right of a company to charge varying premiums in respect of blocks of shares having the same rights issued under different resolutions is not denied, and on principle there is no objection to the charging of varying rates of premium for shares issued under a single resolution, if all the parties concerned agree. The amount or value which a person intending to be a shareholder may pay in excess of the par value for acquiring the shares of a company depends upon the contract between the company and such person. In the case under view, the two transferor companies were willing to combine into a larger corporation, presumably to avoid competition. The book value of the assets transferred by Socony Vacuum Oil Company was undoubtedly larger than the book value of assets transferred by the Standard Oil Company. But for effectuating a combine, the two transferor companies in a contract with the assessee-company agreed to receive stocks of equal par value carrying equal rights in consideration of transfer of assets of different values. If the excess paid by the transf ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ation in excess of the par value of shares, and in the absence of evidence to prove such an arrangement, the capital surplus is not premium realised from the issue of shares. No such contention was raised at any stage in these proceedings, and a finding that there was before the shares were issued an arrangement between the two transferor companies and the assessee-company that the shares were to be issued in consideration of the transfer of assets of unequal book value held by the two transferor companies is clearly implicit in the view expressed by the Tribunal. The High Court was therefore right in holding that the difference between the book value of the assets transferred and the par value of capital stock issued was premium. The assessee-company said that even if this amount of " Capital paid in surplus " be not regarded as premium within the meaning of rule 3, it is still " reserves " within the meaning of rule 2(1). This plea found favour with the High Court. Counsel for the revenue raised two contentions against acceptance of that view of the High Court : (1) that reserves contemplated by rule 2(1) are only those which are built out of profits processed for the purpose ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rs but kept back by the directors for any purpose to which it may be put in future " were only made in reference to the facts of the case and were not intended to lay down that reserves built up from sources other than profits will not be admissible for inclusion in capital under rule 2(1) of the Business Profits Tax Act. This contention is also negatived by the terms of the Explanation. Reserves which may be brought into existence by creating or increasing (by re-valuation or otherwise) any book asset are expressly declared to be not capital for the purpose of ascertaining the abatement. If reserves which were built not out of profit were excluded from the operation of rule 2(1), it was hardly necessary to enact the Explanation. The Explanation to rule 2 has no relevance in the present case. The difference between the assets received by the company and the par value of the snares issued cannot be called a book asset " brought into existence by creating or increasing (by re-valuation or otherwise) ". The assets received by the assessee-company are real and tangible assets. It is only for accountancy purposes that a part of the value of the assets is allocated to the par value ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... llocated amount gets merged in the account of that year. In the system of accounting in the U. S. A. each year's account is self-contained and nothing is carried forward. If after allocating the profits to diverse heads mentioned above any balance remains, it is credited to the ' Undivided profits ' which become part of the capital fund. If in any year as a result of the allocation there is a loss the accumulated ' Undivided profits ' of the previous years are drawn upon and if that fund is exhausted the banking company draws upon the surplus. In its very nature the ' Undivided profits ' are accumulation of amounts of residue on hand at the end of year of successive periods of accounting and these amounts are by the prevailing accounting practice and the Treasury directions regarded as a part of the capital fund of the banking company. " It is true that the court in that case was dealing with a case of a banking company. But the characteristics noted are not peculiar to the accounts of a banking company : they are applicable with appropriate variations to the accounts of all companies, in which different nomenclatures are used in the accounts to designate the residue on hand as ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e 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. The fact that it constituted a mass of undistributed profits on the 1st January, 1946, cannot automatically make it a reserve. On the 1st April, 1946, which is 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 amount in question a reserve, it shows that they had decided to earmark it for distribution as dividend. " After referring to the judgment of the High Court, the learned judge observed : " The directors had no power to distribute the sum as dividend. They could only recommend, as indeed they did, and it was up to the shareholders of the company to accept that recommendation in which case alone the distribution could take place. The recommendation was accepted and the dividend was actually distributed. It is, therefore, not correct to say that the amount was kept back. The nature of the amount, which was nothing more th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... his case dealing with a foreign company and the system of accounting followed by the company is different in important respects from the system which obtains in India. Companies in India maintain diverse types of reserves : such as capital reserve, reserve for redemption of debentures, reserve for replacement of plant and machinery, reserve for buying new plant to be added to the existing ones, reserve for bad and doubtful debts, reserve for payment of dividend and general reserve. Depreciation reserve within the limit prescribed by the Income-tax Act or the Rules thereunder is the only reserve which is a permissible allowance in the computation of taxable profits. In its ordinary meaning the expression " reserve " means something specifically kept apart for future use or for a specific occasion. The accumulated profits of the assessee-company, according to the system of accounting at the end of the year, were not carried forward into the account of the next year as they could not be, according to the system of accounting prevalent in the United States. They had to be allocated to some account, and they were allocated to " earned surplus, " which was intended for and was used in su ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 92 38882589 20000000 92649181 207045227 -------------------------------------------------------------------------------------------------------------------------------------------------- The table disclosed that the balance of " earned surplus " at the end of the year did not merge into the account of the subsequent year. It represented a specific account into which were added the net profits of the year and appropriations were made out of it and the balance was regarded as " earned surplus " at the end of the year. This account was specifically allocated for utilisation for the purpose of business year after year. It was an account in which the net profits less the appropriations were added, and the account was intended for application in extending the business of the assessee-company. The amounts entered in the account " earned surplus " cannot therefore be regarded as mere unallocated profits at the end of the accounting year. The High Court was therefore right in holding that the " earned surplus " represented reserves. The method in which the accounts are maintained in the light of the accountancy practice clearly indicates that, at the end of each year, there have be ..... X X X X Extracts X X X X X X X X Extracts X X X X
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