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TMI Blog1981 (4) TMI 49X X X X Extracts X X X X X X X X Extracts X X X X ..... gnificance. The assessee-bank computed its capital for the purpose of calculating super profits tax, and in doing so it took into consideration the following items as constituting its reserves, viz., (1) Rs. 76,58,687 which represented the amount standing to the credit of the premium and discount account but which was not shown in its balance-sheet; (2) Rs. 1,31,00,548 being the taxation reserve; and (3) Rs. 85,84,302, which were the depreciation reserve. It is common ground that the first amount of Rs. 76,58,687 did not figure in the published balance-sheet of the bank and this was stated to be the amount merged in investments shown in item (4) of the balancesheet relating to the year ending on December 31, 1961. Normally, the balance-sheet for the assessment year in question, viz., 1963-64, would be the balance-sheet as on December 31, 1962, in relation to the calendar year 1962, which is the accounting year followed by the assessee-bank. However, since for super profits tax we are concerned with the first day of the previous year for the computation of capital, it is necessary to look into the figures in the balance-sheet relating to the year prior to the previous year and h ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... as not styled as reserve, was kept to meet some eventualities and, therefore, it could be treated on a par with the reserve for contingency. The Tribunal further accepted that there may not be an express authorisation of the Board on this account and in this connection observed that a decision regarding a secret matter of this nature could not be taken by an executive action the matter being a vital and a crucial one the decision would rest with the Board alone and it alone could take and assume responsibilities in that behalf. The Tribunal, therefore, held that such a reserve must have been created with the requisite authority from the board of directors though the evidence of such authority was not available. The Tribunal also took the view that the transfers to the said account could not be made by an express act of authority as in the case of other appropriations which were brought to the notice of the shareholders and the members of the public. The Tribunal, therefore, held that the said premium and discount account was reserve and, therefore, was eligible to be considered as capital base for the computation of capital base under the Act. As regards the taxation reserve, the T ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he assessee that in view of the decision of the Supreme Court in CIT v. Damodaran [1980] 121 ITR 572, the last two questions could not have been referred by the Tribunal in an application for reference by the revenue. Hence, it is not necessary for as to answer the said two questions. As stated earlier, therefore, the question that falls for consideration in this case is whether the Tribunal was right in its view that the said amount of Rs. 76,58,687 representing the balance standing in the premium and discount account and not disclosed in the published balance-sheet of the assessee-bank could be treated as a reserve and included in the capital base for the purpose of calculation of excess profits under the Act, viz., the S.P.T . Act, 1963. Admittedly, the assessee-bank has been treating this amount as what is called a secret reserve and, as has been stated earlier, it was not shown in the published balance-sheet for the relevant year. It is also not disputed that there is no record of the authority to authorise the appropriation of the said amount to the said secret reserve account. Not only that, the amount does not appear in so many figures anywhere and it has to be inferred f ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... its " chargeable profits " of the previous year as exceed the " standard 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 I.T. Act, 1961, for any previous year and adjusted in accordance with the previsions of the First Schedule. 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 larger. 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 r. 1, which is relevant for our purposes, so far as it is material, is 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... -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, as stated earlier, 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 that amount a sum of Rs. 4,92,426 should be distributed as dividend and the balance of Rs. 16,211 should be carried forward to the next year's account. This recommendation was accepted by the shareholders in their meeting held on April 3, 1946, and the amount was shortly thereafter distributed as dividend. In computing the capital of the assessee-company on January 1, 1946, under the Business Profits Tax Act, 1947, the assessee claimed that the said sum of Rs. 5,08,637 and the profit earned by it during the period January 1, 1946 to April 1, 1946, should be treated as reserves for the purposes of the said rule. The High Court held that the sum of Rs. 5,08,637 must be treated as a reserve for the purpose of the said rule, but the profit made by the assessee during the period January 1, 194 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 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. By the resolution of the shareholders on the 3rd April, 1946, the amount was shortly afterwards distributed as dividend ...... 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 than the undistributed profits of the company, remained unaltered. Thus the profits lying unutilised and not specially set apart for any purpose on the crucia ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... indicate the manner of its disposal or destination. If the surplus is simply carried forward without the persons in requisite authority allocating it to any particular purpose as a reserve, it does not acquire the character of a reserve for the purpose of capital computation under the Business Profits Tax Act. In that case, the balance-sheet of the assessee-company for the year ending March 31, 1946, showed a sum as unappropriated balance. This sum was made up of two smaller sums, viz., (i) an amount which had been carried forward out of the balance as at the last date of the previous year, i.e., as on March 31, 1945, and (ii) an amount which was the balance of the profits for that year, 1945-46. The assessee claimed that it was entitled to have the entire sum treated as reserve for the purposes of the computation of its capital for the chargeable accounting period ended March 31, 1947, under r. 2(1) of Sch. II to the Business Profits Tax Act, 1947. The Tribunal allowed the assessee's claim with regard to the amount carried forward from the previous year 1944-45 but rejected its claim in respect of the balance of the profits for the year 1945-46. The High Court, on a reference, he ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e of the balance-sheet. Secret reserves may be created deliberately by : 1. Writing down assets below their market value by excessive provision for depreciation. 2. Writing off assets altogether, although they are still of value. 3. Creating excessive provisions for bad debts. 4. Charging capital expenditure to revenue. 5. Omitting goodwill from the accounts. 6. Overstating liabilities in the balance-sheet. 7. Treating reserves for contingencies as provisions for specific liabilities. 8. Grouping free reserves with liabilities, so as to inflate the liabilities on the balance-sheet. 9. Crediting exceptional or non-recurring profits direct to a contingencies reserve, and including such reserves in the liabilities on the balance-sheet. The following objections may be made against the practice of creating and maintaining secret reserves : 1. The resulting balance-sheet will not disclose a true and fair view as the assets will be understated and/or the liabilities overstated. 2. The Profit and Loss Account, where affected, will not show the correct profit, and consequently the divided declared may be less than would otherwise have been possible., ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ty as an actual liability or as a provision therefor; or an actual asset as a contingent asset. (f) Grouping of 'free' reserves with creditors. (g) Crediting exceptional or non-recurring profit to a contingencies reserve without proper disclosure. (h) Allowing undistributed surplus in the hands of a subsidiary company. An example of the creation of a secret reserve is seen where a bank provides for depreciation of investments, but does not re-credit a subsequent appreciation of investments. From this it will be seen that secret reserves may, (i) arise, as in (d), (ii) be created, as in the remainder of the examples given, (iii) be maintained, by allowing (i) to remain or by continuing the practice in (ii). " So also in Batliboi's Advanced Accountancy, 27th edn., at p. 724, a similar explanation is given with regard to secret or inner reserves. It will thus appear from the aforesaid description of secret reserves given in the text books that there are various modes of forming secret reserves and one of the ways is to undervalue the stocks of shares and securities. Since such an operation reduces the value of the assets without the fact being disclosed i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sheet and the profit and loss account will have to be signed, whenever there is a board of directors, by the directors show that the statement made in the balancesheet and the profit and loss account when signed will be deemed to have been perused by them and their appropriation of the amounts to the different accounts will be deemed to have been done under their authority. Section 30 refers to the audit of the account, section 31 refers to the submission of returns by the assessee to the Reserve Bank, and s. 32 contains a provision with regard to furnishing of balance-sheets and accounts to the Registrar under the Companies Act. Section 34A then lays down that no banking company shall be compelled by any authority to produce or give any inspection of its books of account or any document or furnish or disclose any statement or information in any proceeding before it when the banking company claims that such document, statement or information is of a confidential nature and such information would disclose information relating to any reserves not shown as such in its published balancesheet or any particulars not shown therein in respect of provisions made for bad and doubtful debt ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... as distinguished from other trading and industrial organisations. There was urgent need to protect from disclosure certain of the items of appropriation by banks in order to preserve them as credit institutions. On the other hand, there was the need an equally urgent need-for enabling the workers in these institutions not to be denied a proper wage and other emoluments and proper conditions of service. The question was how far information which in the interests of national economy the banks were entitled to withhold from their shareholders and the general public, was to be made available for determining the capacity of the banks to pay their employees. It was in these circumstances that the impugned legislation was enacted which, while preserving industrial adjudication in respect of disputes between the banks and their employees, entrusted the duty of determining the surplus reserve which could be taken into account as part of the assets for determining capacity to pay, to the Reserve Bank. Thus understood there does not appear to be anything unreasonable in the solution which the impugned legislation has effected." These observations will further show that even the Supreme Co ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on Act, the banking company is entitled not to disclose, among other things, its secret reserves. Hence, the balance-sheet as published by any banking company will have to be taken as disclosing or reflecting the true and fair affairs of the company and cannot be questioned for want of express information with regard to the secret reserves. This will also mean that if the company claims that it has maintained secret reserves, that claim will have to be accepted in spite of the fact that they are not reflected in the published balance-sheet or accounts. It will also have further to be accepted that such reserves are kept at the instance of the board of directors of the company. That is so because even by virtue of s. 215 of the Companies Act, 1956, read with s. 29(2) of the Banking Companies Act, 1949, the balance-sheets have to be signed by the board of directors before they are submitted to the auditors for their report thereon. Subs. (3) of s. 217 of the Companies Act further requires that the board is bound to give the fullest informations and explanations in its report made to the general meeting on every reservation, qualification or adverse remarks contained in the auditor's ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e whether and to what extent and what at times and places and under what conditions or regulations, the accounts and books of the company, or any of them, shall be open for inspection by the members who are not directors. Sub-clause (2) of the said regulation further lays down that no member (not being a director) shall have any right of inspecting any account or books or documents of the company except as conferred by law or authorised by the board or by the company in general meetings. Therefore, it is correct to say that the authority to allocate funds to different accounts does not necessarily vest in the shareholders of the company unless there is an express provision for the same. As far as the present case is concerned, sub-cl. (19) of art. 109 of the articles of association of the assessee-company gives a power to the directors of the company which reads as follows : " Before recommending any dividend, to set aside out of the profits of the company, such sums as they think proper as a reserve fund to meet contingencies, or for equalising dividends, or for special dividends, or for repairing, improving, and maintaining any of the property of the company and for such other ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nce-sheet is an entry under the head " Investments at below market value ". The wording of the heading of the said item is itself eloquent and an intelligent reader can at once gather from the said entry that the said investments have been valued at below the market value for the obvious purpose of creating secret reserves. As has been pointed out earlier, in the books of account the mode by which the said figure of Rs. 76,58,687 has been shown to have been arrived at is by working out the difference between the market value of the securities and shares which is shown as Rs. 23,00,71,555.37 and the market value of the investments which is shown as Rs. 22,24,12,868.18 (which is the figure which is shown as the total value of the items mentioned in the said entry No. 4). The figure of Rs. 76,58,687.19 is shown in the books of account as standing to the credit of the account which is called the premium and discount account. This figure, as stated earlier, reflects the balance after the sale of shares and securities. It is because the assessee-company has stated the amount standing to the credit of the said account, that the company is impelled to show the value of its total investment ..... X X X X Extracts X X X X X X X X Extracts X X X X
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