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TMI Blog1995 (2) TMI 16X X X X Extracts X X X X X X X X Extracts X X X X ..... ssee that the reserve created for debenture redemption should also be treated as part of the capital and appropriate relief given in arriving at the standard deduction, mainly on the ground that the assessee had created the reserve for the purpose of meeting a specific liability, viz., repayment of debenture loan, and, consequently, it could not be regarded as a reserve. On appeal, the Commissioner (Appeals) held a different view. According to him, the amount of money set apart for repayment of debentures was a reserve and not a provision. The Tribunal affirmed the order of the Commissioner (Appeals) and dismissed the Department's appeal. Before we advert to the reasons assigned by the Tribunal for the above view, we may scan the relevant provisions of the law and prospect into the judicial pronouncements so that we may reach a proper and correct delineation of the area in which the Surtax Act operates. The Surtax Act was enforced to impose a special tax on the profits of companies in respect of so much of their chargeable profits of the previous years as exceeded the statutory deduction at the rate or rates specified in the Third Schedule of the Act for every assessment year com ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r a company which has made the prescribed arrangements for the declaration and payment of dividends within India ; (viii) income by way of royalties received from Government or a local authority or any Indian concern ; (ix) in the case of a non-resident company which has not made the prescribed arrangements for the declaration and payment of dividends within India, its income by way of any interest or fees for rendering technical services received from Government or a local authority or any Indian concern ; (x) the amount of any deduction from the income-tax chargeable on the total income allowed under the annual Finance Act in connection with export of any goods or merchandise out of India or the sale by a manufacturer of any articles to any person who exported them out of India. (xi) In the case of a banking company, any sum which, during the previous year is transferred by it to a reserve fund under sub-section (1) of section 17 of the Banking Companies Act, 1949 (10 of 1949), or is deposited by it with the Reserve Bank of India under sub-clause (ii) of clause (b) of sub-section (2) of section 11 of that Act, not exceeding the amount required under the aforesaid provisio ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e of every relief due under the said laws provided that the assessee produced evidence of the fact of payment of the said tax in that country. Rule 3 contemplated increase in the net amount of income calculated in accordance with the procedure as found by the aggregate of (i) the amount of any interest payable by the company in respect of the debentures referred to in clause (iv) or moneys referred to in clause (v) of rule 1 of the Second Schedule for the previous year relevant to the assessment year allowed as a deduction in computing its total income and (ii) the expenditure incurred on account of commission, entertainment and advertisement, to the extent such expenditure, in the opinion of the Income-tax Officer, is excessive having regard to the circumstances of the case, but for holding such expenditure to be excessive the previous authority of the Inspecting Assistant Commissioner was necessary. The Second Schedule which contained rules for computation of the capital of a company for the purpose of surtax deduction provided, inter alia, that 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... eserves ; (7) Sinking, funds. The items included in the column of " Liabilities " and the form of balance-sheet given in Part I of Schedule VI to the Companies Act, 1956, were obviously intended to be incorporated in accordance with the instructions as were/are indicated in a separate column in the Schedule and in accordance with the requirements as to profit and loss account as were/are in Part II of the Companies Act, Rules. The Explanation has thus left for computing the capital of a company for the purpose of surtax reserves (i) Capital reserve ; (ii) Capital redemption reserve ; (iii) Share premium account, and (iv) other reserve specifying the nature of each reserve and the amount in respect thereof for the purpose of computation of the capital of a company under the provisions of the Second Schedule to the Surtax Act. The reserve, that is the amount equal to 75 per cent. of the development rebate to be actually allowed debited to the profit and loss account of the relevant previous year and credited to a reserve account to be utilised by the assessee during the period of eight years next following for the purposes of the business of the assessee other than for distri ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... eciation, renewals or diminution in value of assets or retained by way of providing for any known liability ; (c) the expression 'capital reserve' shall not include any amount regarded as free for distribution through the profit and loss account ; and the expression 'revenue reserve' shall mean any reserve other than a capital reserve ; and in this sub-clause the expression 'liability' shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities. (2) Where,-- (a) any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, not being an amount written off in relation to fixed assets before the commencement of this Act ; or (b) any amount retained by way of providing for any known liability ; is in excess of the amount which in the opinion of the directors is reasonably necessary for the purpose, the excess shall be treated for the purposes of this Schedule as a reserve and not as a provision. " This rule suggests that " reserve " shall not include any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets or ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ccount against gross receipts in the profit and loss account and the balance-sheet ; (4) Reserves are appropriations of profits, the assets by which they are represented being retained to form part of the capital employed in the business ; (5) " provisions " are usually shown in the balance-sheet by way of deductions from the assets in respect of which they are made whereas general reserves and reserve funds are shown as part of the proprietor's interest ; (6) the preparation of the balance-sheet as well as the profit and loss account in the prescribed forms and laying the same before the shareholders at the annual general meeting are statutory requirements which the company has to observe. The form of balance-sheet as given in Part I of Schedule VI contains separate heads of " Reserves and surplus " and " Current liabilities and provisions " and under sub-head " Reserves " different kinds of reserves are indicated and under sub-head " Provisions " different types of provisions are indicated. Referring to Part III of Schedule VI to the Companies Act, the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559 has said : " Part III is the interpretation clause setting out the d ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ratuity ; (3) provision for proposed dividends in the case of concerned assessee-companies. With respect to provision for taxation, the Supreme Court has referred to one of its earlier judgments in the case of Kesoram Industries and Cotton Mills Ltd. v. CWT [1966] 59 ITR 767 and stated (at page 572) : " The ratio of this decision clearly suggests that the appropriation of the amounts set apart by the assessee-companies before us for taxation would constitute a provision made by them to meet a known and existing liability and as such the concerned amounts would not be includible in the capital computation. " With respect to the item of appropriation made for retirement gratuity, the Supreme Court has said (at page 574) : " Ordinarily an appropriation to gratuity reserve will have to be regarded as a provision made for a contingent liability, for, under a scheme framed by a company the liability to pay gratuity to its employees on determination of employment arises only when the employment of the employee is determined by death, incapacity, retirement or resignation--an event (cessation of employment) certain to happen in the service career of every employee ; moreover, the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... latter, to what extent in the light of the above principles. On the third item of appropriation by way of provision for the proposed dividends, the Supreme Court took notice of section 217 of the Companies Act, 1956, and pointed out that the directors of a company can merely recommend that a certain sum be paid as dividend but such recommendation does not result in any obligation or liability ; the obligation or liability to pay the dividend arises only when the shareholders at the annual general meeting of the company decide to accept the recommendation and pass a resolution for the declaration of dividend, to hold (at page 579) : " All that follows from the above is that, in the instant cases, the appropriation of the concerned amounts by the board of directors by way of providing for proposed dividend would not constitute 'provisions', for, the appropriations cannot be said to be by way of providing for any known or existing liability, none having arisen on the date when the directors made the recommendation much less on the relevant date being the first day of the previous year relevant to the assessment year in question. But, as stated earlier, this by itself would not a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... become a reserve and that somebody possessing the requisite authority must clearly indicate that a portion thereof has been earmarked or separated from the general mass of profits with a view to constituting it either as a general reserve or a specific reserve, (b) the surrounding circumstances should make it apparent that the amount so earmarked or set apart is in fact a reserve to be utilised in future for a specific purpose and on a specific occasion, and (c) a clear conduct on the part of the directors in setting apart a sum from out of the mass of undistributed profits avowedly for the purpose of distribution as dividend in the same year would run counter to any intention of making that amount a reserve. It was because of these aspects obtained in the case that this court took the view that neither the sum of Rs. 5,08,637, nor the profits earned by the assessee during the period 1st January, 1946, to 1st April, 1946, constituted 'reserve' within the meaning of rule 2(1) of the Second Schedule to the Business Profits Tax Act, 1947. " The court then considered two more decisions, one in First National City Bank v. CIT [1961] 42 ITR 17 (SC) and the other in CIT v. Standard Va ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y are represented, is being retained to form part of the capital employed in the business. The appropriation of any money set apart by way of providing for known or existing liability would constitute a " provision ". If it is in respect of a liability which is yet to accrue, it is not known when shall it accrue and what would be its approximate quantum, it may be a " reserve " if it further satisfies that it has been earmarked for a purpose and separated from the general mass of profits to be utilised in future for a specific purpose and on a specific occasion. The Explanation appended to rule 1 to the Second Schedule to the Surtax Act has, in particular, referred to the nature of item (5) or item (6) or item (7) under the heading " Reserve and surplus " in the form of balance-sheet given in Part I of Schedule VI to the Companies Act, 1956, and of any item under the heading, " Liabilities " in the said form to exclude such reserve from the capital computation and thus leave capital reserve, capital redemption reserve, share premium account and other reserves specifying the nature of each reserve and the amount in respect thereof less debit balance in the profit and loss account, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d. [1986] 158 ITR 332 which dealt with a reserve for debenture redemption in which the ratio decidendi or the principles laid down in Vazir Sultan Tobacco Co. Ltd.'s case [1981] 132 ITR 559 (SC) are reiterated and applied. The assessee created a reserve for contingencies according to the provisions of the Electricity (Supply) Act, 1948. It contended that the said " reserve " was required to be appropriated for specific expenditure as provided for in rule V of the Sixth Schedule to the Electric (Supply) Act, 1948. After referring to the contentions of the parties, the Calcutta High Court has observed (at page 336) : " No facts could be ascertained from the order of the Income-tax Officer or the Appellate Assistant Commissioner. It was submitted by the assessee before the Tribunal that the assessee-company had issued 1,500 debentures of Rs. 100 each during the year, 1951. According to the terms of the debenture issue, the company was required to redeem 60 debentures of the total of Rs. 60,000 every year. According to the Second Schedule to the debenture trust deed dated July 26, 1951, the assessee was required to credit an amount of Rs. 60,000 every year to the debenture redemption ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... cumulated profits, without more, would not answer the description of reserve. " and " The debenture trust deed dated July 26, 1951, is not available before us. It has not been annexed to the statement of the case. It is not known what was the scientific basis of payment of Rs. 60,000 every year to debenture-holders and whether any excess provision is made every year. In the absence of proper material touching on this crucial aspect, we are unable to decide the controversy. The matter has to be remanded to the Tribunal who shall decide this controversy in the light of the principles laid down by the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559 after ascertaining the necessary facts. " The Bombay High Court, in the case of CIT v. National Rayon Corporation Ltd. [1986] 160 ITR 716, has dealt with a case of gratuity reserve and noted that it was necessary to know whether the appropriation made by the assessee towards gratuity reserve was based on any actuarial valuation or was in the nature of appropriation of an ad hoc amount and followed the course adopted by the Supreme Court in Vazir Sultan Tobacco Co. Ltd.'s case [1981] 132 ITR 559 since there was no sufficient mate ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rden and was not utilised for any purpose and was transferred to the general reserve, the Supreme Court held, " was rightly treated as a reserve which qualified for computation in the capital ". On the item called investment reserve, which was created out of the surplus on the sale of investment which was not held by the respondent-company as its stock-in-trade, and which did not have its origin in business profits and was transferred directly to the reserve account but was created prior to 1954 and was further credited in 1955 to 1957 out of the profits and sale of investments, the Supreme Court noticed (at page 745) : " In the later years, whenever a loss of a capital nature was incurred, it was debited to this account. It appears that at the time of creating this reserve, the directors could not have possibly anticipated the losses which might occur in future but merely created a reserve so that losses which do normally arise in the course of business might be adjusted against this amount. It appears, therefore, that this was a reserve created out of capital profit. This reserve can rightly be treated as other reserves. " The Supreme Court reiterated its view expressed in El ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in the case of CIT v. Modi Industries Ltd. (No. 2) [1992] 197 ITR 655 has held that a debenture redemption fund which was created by appropriation of profits from the profit and loss appropriation account, when there was no liability of the current year which had to be met by the said fund in redeeming debentures in that year, and the funds had been set apart for use only in future, was a reserve and had to be included in the capital base for the purpose of the Companies (Profits) Surtax Act. The same view is expressed by the Gujarat High Court in Commissioner of Surtax/Income-tax v. Ahmedabad Mfg. and Calico Printing Co. Ltd. [1995] 211 ITR 270, in respect of a debenture redemption reserve account, for (at page 272) : " It has come on record that these amounts were transferred to the general reserve account by the assessee and they were not utilised with a view to meet any known or anticipated liability. " We have taken a close view and noticed that it is not the nomenclature of a reserve which will give any clue as to whether it is a provision and thus not a reserve and if not a provision, it is a reserve which shall qualify for computation in the capital for the purposes o ..... X X X X Extracts X X X X X X X X Extracts X X X X
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