1976 (9) TMI 3 - SC - Income Tax

Development rebate reserve - Treatment of accumulated profits of the company within the meaning of section 2(6A)(e) of the Act - profit and loss account - dividend - Word capitalisation - HELD THAT - The profits of a company can be capitalised in accordance with the articles of association and the law. On the capitalisation of the profits they cease to be profits in the hands of the company. The nature of the asset is changed although it does not make any difference in the total assets of the company. But profits stand transmuted and transformed into capital. The most common example of capitalisation of profits is by issuance of bonus shares to the shareholders. Clauses (a) to (d) were intended by the legislature to cover the cases of accumulated profits even though they may be capitalised. But the legislature did not intend to rope in the capitalised profits in clause (a). We may add that though under clause (b) distribution by a company of debentures debenture stock or deposit certificates in any form in lieu of capitalised profits is to be deemed dividend within the meaning of sub-section (6A) mere distribution of bonus shares after capitalising the accumulated profits unless the distribution entails the release by the company to its shareholders of any part of the assets of the company is not to be a deemed dividend. Even under the 1961 Act distribution of bonus shares to the equity shareholders after capitalising the profits in accordance with law is not to be a deemed dividend although distribution of such shares to preference shareholders is. It is thus clear that if money is paid to a shareholder of a private company by way of advance or loan after the accumulated profits have been capitalised in accordance with the law and the articles of association then such payment although it may represent a part of the assets of the company or otherwise cannot be co-related to the capitalised profits of the company. To the extent the profits have been capitalised the company cannot be said to possess any accumulated profits. But the obvious difficulty in the way of the appellant is that the accumulated profits of the company in the year in question were never capitalised. Mere transferring the sum by debiting it to the profit and loss account to the development reserve account did not amount to the capitalisation of profits. The nature of the assets in the hands of the company did not change. It remained profits in the hands of the company. Thus we hold that the development rebate reserve created by the company by duly charging the amount of profit and loss account although liable as a deduction under the 1922 Act constituted accumulated profits of the company within the meaning of section 2(6)(e). We accordingly affirm the decision of the High Court dismiss this appeal but in the circumstances make no order as to costs. Appeal dismissed.

The judgment revolves around an appeal by an assessee concerning the interpretation of "accumulated profits" under section 2(6A)(e) of the Indian Income-tax Act, 1922, in relation to the development rebate reserve created by a company. The core issue is whether the development rebate reserve can be considered accumulated profits for the purpose of taxing deemed dividends.

Issues Presented and Considered

The primary legal question considered is whether the development rebate reserve, created by a company and charged to its profit and loss account, constitutes "accumulated profits" within the meaning of section 2(6A)(e) of the 1922 Act. This determination impacts whether withdrawals by a shareholder from a company can be taxed as deemed dividends.

Issue-wise Detailed Analysis

Relevant Legal Framework and Precedents

The case hinges on the interpretation of section 2(6A)(e) of the 1922 Act, which defines "dividend" to include any payment by a company to a shareholder, to the extent the company possesses accumulated profits. The concept of "accumulated profits" is crucial, as it determines the taxability of advances or loans as deemed dividends. The Court examines various precedents and legal interpretations to ascertain the meaning of "accumulated profits" in a commercial sense, distinct from assessable or taxable profits.

Court's Interpretation and Reasoning

The Court emphasizes that "accumulated profits" must be understood in a commercial sense, not merely as assessable profits under tax law. It draws on the distinction between commercial profits and taxable income, highlighting that commercial profits reflect the true gain of a business, while assessable income may include fictional elements due to tax rules. The Court references authoritative sources and prior judgments to support this interpretation.

Key Evidence and Findings

The Court finds that the development rebate reserve, though deductible from assessable profits, remains part of the commercial profits of the company. It rejects the argument equating development rebate with normal depreciation, noting that the rebate serves as an incentive for installing new machinery rather than an ongoing business expense. The Court also considers the legislative intent behind section 2(6A) and its amendments, which aim to include certain payments as deemed dividends for taxation.

Application of Law to Facts

Applying the legal framework, the Court concludes that the development rebate reserve is indeed part of the accumulated profits of the company. It reasons that the rebate, while reducing tax liability, does not alter the nature of profits in a commercial sense. The Court distinguishes between capitalized profits, which lose their character as profits, and reserves, which do not change the nature of the profits.

Treatment of Competing Arguments

The Court addresses the assessee's argument that the development rebate should be treated as a deductible cost similar to depreciation. It refutes this by clarifying the distinct nature and purpose of development rebates as incentives rather than cost allowances. The Court also considers the absence of the phrase "whether capitalised or not" in clause (e) and concludes that it does not exclude development rebate reserves from being considered accumulated profits.

Significant Holdings

The Court holds that the development rebate reserve constitutes accumulated profits within the meaning of section 2(6A)(e), thereby affirming the High Court's decision. It establishes the principle that development rebates, while deductible for tax purposes, remain part of the commercial profits of a company. The Court's final determination is that the appeal by the assessee is dismissed, with no order as to costs.

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