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TMI Blog1980 (2) TMI 60X X X X Extracts X X X X X X X X Extracts X X X X ..... s defined to represent the sum of the amounts of " 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. " The Super Profits Tax Act, 1963, also laid down a similar rule. Here again, the super profits represented the excess of its chargeable profits of a previous year over the standard deduction, which represented an amount equal to 6% of the capital of the company as computed in accordance with the provisions of the Second Schedule. The Second Schedule contained rules for computing the capital of a company for the purposes of the Act. Rule 1 of the Schedule, in effect, so far as is material for our purposes, provided that 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 reserves except those which are allowed as deductions in computing the profits of the company for the purposes of the Indian I.T. Act, 1922, or the I.T. Act, 1961. It will be seen that both the above enactments were identical in their terms. They did not contain any definit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... lso that any item displayed against items Nos. (5), (6) and (7) in the balance-sheet under the heading " Reserves and Surplus " shall also not be treated as a reserve. It may be clarified here that on the liabilities side of the balance-sheet, there first appear the figures of the share capital of the company followed by various items under the head " Reserves and surplus ". Items (5), (6) and (7) are as follows: . " (5) Surplus, i.e., balance in profit and loss account after providing for proposed allocations, namely:-- Dividend, Bonus or Reserves. (6) Proposed additions to Reserves. (7) Sinking Funds." Then follow the headings " Secured loans " and " Unsecured loans ". Then occurs the heading " Current liabilities and provisions ". Under the head " Current liabilities " are to be shown the liabilities of the company towards " acceptances, sundry creditors, subsidiary companies, advance payments and unexpired discounts, unclaimed dividends ", other liabilities, if any, and liability by way of interest accrued but not due on loans. Under the sub-head " Provisions " mention is made of provision for taxation, for proposed dividends, for contingencies, for provident funds sc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ovisions of the Super Profits Tax Act, 1963, an amount standing to the credit of " the gratuity reserve " of the Orissa Cement Ltd., New Delhi as on the first day of January, 1962, relevant for the previous year ended on December 31, 1962, would constitute a " reserve " includible in the capital base of the company. The ITO took the view that this amount represented a provision for a known contingent liability and was, therefore, not a reserve. On appeal, the AAC, after pointing out that the reserve for gratutity was not allowed by way of deduction for computing the profits under the I.T Act and that the amount had been shown by the assessee in the balance-sheet under the head " Reserves and Surplus ", was inclined to agree that the gratuity reserve was not a provision but a reserve as contemplated in r.1 of the Second Schedule to the Super Profits Tax Act, 1963. This view of the AAC was upheld by the Tribunal. The Tribunal referred to the dictionary meaning of the word " reserve " and observed that in the present case " the assessee has kept back such portion of the profits and created a reserve in the shape of gratuity reserve, in order to meet its obligation to pay gratuity to i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... . Co. Ltd. [1951] 20 ITR 260, 265 (Bom)): " A reserve in the sense in which it is used in rule 2 can only mean profit earned by a company and not distributed as dividends to the shareholders but kept by the directors for any purpose to which it may be put in future. " and again at page 266 : " It is not sufficient for the company to earn profits. Having earned profits it must then by some conscious act determine what part of these profits should be kept back. It is only when part of these profits is kept back that it constitutes reserves. We are told that these profits were used in business and, therefore, they constitute reserves. But, what makes a part of the profits reserves is not the fact that they are used in the business but that they are consciously kept back and not distributed amongst the shareholders as dividends. " In that case, the High Court had held that, since the directors had not actually distributed the amount in question as dividends but kept it back, it constituted a reserve. The Supreme Court only pointed out that this application of mind and holding back should be by a competent authority. It was pointed out that, under the Companies Act, the director ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ecessary to refer to certain decisions of the Supreme Court. One of these is of general guidance while the others explain the nature of the liability of a company in respect of gratuity payable to its employees. In Kesoram Industries and Cotton Mills Ltd. v. CIT [1966] 59 ITR 767, the Supreme Court had to consider the question whether the liability of a company for payment of income-tax for a particular accounting year could be treated as a " debt owed " by the company as on the last date of the accounting year for purposes of the W.T. Act, 1957. The Supreme Court answered the question in the affirmative. It was pointed out that the liability to pay income-tax arose as on the last day of the accounting period and that, though the quantum thereof would normally be ascertained only on assessment, there can be no doubt that there was in existence a liability in praesenti as on the last date of the accounting year and this was sufficient to constitute a debt owed by the company on that date. On the principle of the above decision, the question arose whether the amounts payable by a company by way of gratuity to its various employees could be claimed as deductions for purposes of th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... upon the determination of employment. " Referring to Kesoram's case [1966] 59 ITR 767 (SC), it was pointed out that the decisions approved in that decision " also accepted the legal position that a liability depending upon a contingency is not a debt in praesenti or in futuro till the contingency happened ". That case only decided that, if there was a present liability, the fact that the amount is to be a certained does not make it any the less a debt since the liability is certain and what remains is only the quantification of the amount. The decision of the House of Lords was distinguished on the ground that it was a case concerned to determine the deductibility of the present value of a liability which may arise in future in the computation of taxable profits for the relevant year under the I.T. Act but that the same considerations could not apply to a case under the W. T. Act where the liability to pay wealth-tax is charged upon the net wealth of an assessee. The view to the contrary that contingent liabilities could also be taken into account while computing the net wealth of assessee, taken in New Rajpur Mills' case [1965] 56 ITR 544 (Guj), was disapproved. The same ques ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rs. According to the company, the estimated liability under this scheme worked out to Rs. 20 lakhs but instead of providing for the whole of it, it provided only Rs. 11.38 lakhs. The sums of Rs. 7 lakhs and Rs. 11.38 lakhs thus set apart for the two schemes were debited in the profit and loss account and this went to reduce the gross profits. The employees' union objected contending that only a sum of Rs. 2.18 lakhs that had been actually paid during the year as gratuity to those who retired could be deducted and not the balance. What the Tribunal did, however, was that instead of squarely facing this controversy, it held that as the company had debited only Rs. 5 lakhs in 1959-60 and 1961-62 it would allow only Rs. 5 lakhs for each of these schemes. In addition to this sum of Rs. 10 lakhs it allowed the actual payment of Rs. 2.18 lakhs and added back the sum of Rs. 6 lakhs to the figures shown by the company. In this state of facts, two questions arose for the consideration of the Supreme Court : (1) Whether it was legitimate in such a scheme of gratuity to estimate the liability on an actuarial valuation and deduct such estimated liability in the P L Account while working out ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nder the W.T. Act, if properly ascertainable and its present value fairly discounted, was deductible from the gross receipts while preparing the P L Account. This was recognised in trading circles and there was no rule or direction in the Bonus Act which prohibited such a practice. The second question which the court had to consider was whether the amount so set apart was a provision or a reserve. The court observed . " The distinction between a provision and a reserve is in commercial accountancy fairly well known. Provisions made against anticipated losses and contingencies are charges against profits, and, therefore, to be taken into account against gross receipts in the P L account and the balance-sheet. On the other hand, reserves are appropriations of profits, the assets by which they are represented being retained to form part of the capital employed in the business. 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 . An amount set aside out of profits and other surpluses, not designed to meet a liability, co ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ployees' gratuity fund respectively for the accounting periods ending on October 31, 1956, and October 30,1957, and in its balance-sheets showed these amounts under the head " Current Liabilities and Provisions ". The assessee also credited to the account of each one of its employees, the amount of gratuity payable under the agreement. The ITO allowed deduction of Rs. 3,078 and Rs. 425, being the amounts actually disbursed as gratuity during those years and disallowed the balance. The High Court, however, held on a reference, that the entire provision made by the assessee for payment of gratuity was in the nature of a revenue expenditure and was allowable under the I.T.Act. It was held that the gratuity payable to an employee represented a part of the emoluments payable to him for rendering service during each year. The right to receive gratuity accrued to the employee as soon as he completed an year of service, and, as a corollary, the liability to pay the gratuity to the employee arose to the assessee at the end of each year. The amount of liability was also ascertainable and there was no question in this case of the discounted present value of the liability not being ascertainab ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nds when they arise. Southern Railway of Peru [1957] 32 ITR 737 (HL) and Metal Box [1969] 73 ITR 53 (SC) have approved of this procedure for income-tax purposes and for other purposes such as computation of bonus wherein profits of each year have to be understood in a commercial sense. Thus, where an assessee on some scientific or actuarial basis estimates the present value of the future liability and debits it to the P L account, such an estimate can be allowed as a deduction and would be chargeable against the profits both for income-tax purposes as well as for the purposes of the Bonus Act. However, it is not always necessary to insist on a scientific or actuarial assessment. In the case of a small employer and a comparatively simple scheme of gratuity under which the gratuity is payable in almost every case and the possibility of an employee not being entitled to gratuity is very uncertain or remote, the employer may credit to the account of each employee and charge against each year's profits a portion of the salary of the employee on the basis of which he is entitled to gratuity and claim it as a deduction. In these cases, though some decisions have referred to a present li ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e said, though it is a future liability, that where an assessee has ascertained its present value on a scientific, actuarial or other acceptable basis, he can be said to be providing for a known liability the amount of which has been ascertained and that, therefore, the amounts set apart cannot be said to be " reserves ". It is pointed out that in the Metal Box case [1969] 73 ITR 53 (SC) as well as in certain other cases to which reference will be made later, the claim of the assessee was based upon amounts ascertained in a scientific manner as representing the present value of the future liability. In such cases alone, it is contended, it is open to an assesses to claim the amounts set apart as charge against the year's profits and to the department to treat the amounts set apart as provision. In all other cases, according to the assessee, the allocation being for a future contingent liability would be only in the nature of a reserve. It seems to us that, in deciding the issue before us, it is necessary to bear in mind that the legislature has chosen not to define the word It reserves " in this Act. It has, therefore, to be interpreted very widely on the lines of the dictionary ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... a period of 20 years and amounts are set apart by the company from year to year to meet this future liability the funds though set apart in the accounts, would continue to be employed in the business for years together and it would be most inappropriate to call it a provision, as would follow if the contention of the department were accepted. If, in such a case, the company never set apart any sum towards the future liability and merely added to its general reserves,then the liability cannot be deducted in the computation of the capital of the company and it would be illogical, merely because the company set apart year after year some amounts out of its profits to meet the future liability, to treat the amounts set apart as mere provisions and not as reserves. We think that, as rightly pointed out by Shri Desai, counsel for the assessee, the correct test would be whether the amount is set apart towards items whose nature can be described truly as a charge against the annual profits of the company or whether the amounts so set apart continue to be under the proprietorship of the company and capable of being disposed of by it as it likes. In this context, we should not go by the def ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... its accounts in that way and that it would be commercially prudent to charge the annual profits with such amounts so as to be in a position to meet the liability as and when it arises in future. So an assessee does not change the nature of the amount, if instead of charging it against profits, he sets it apart out of the profits and such an allocation can be rightly treated as a provision, for, truly speaking, it should even have been deducted in arriving at the true profits. But we do not think any assessee can be compelled to make up his accounts in that particular way or make any such scientific provision for the future. It can choose to merely set apart ad hoc slims of money towards the same which may or may not be sufficient to meet that liability in future. Such an allocation cannot be treated as a provision. In the present case, the assessee has not made any allotment or allocation on the principles referred to earlier. It is merely an ad hoc allocation of a certain sum of money which is shown in the books as gratuity reserve. This is a part of the general funds of the company and held by the company for its future use. All that the company means by transferring it to the gr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Steel Rolling Mills Ltd. [1973] 92 ITR 78 held that "amounts set apart for payment of gratuity, a contingent and future liability, and which have been used for the purposes of the business of the company " should be treated as a " reserve " within the meaning of the Act. The court referred to its earlier ruling in CIT v. Vasantha Mills Ltd. [1957] 32 ITR 237, under the Business Profits Tax Act, wherein amounts set apart for payment of income-tax and excess profits tax were held to constitute reserves. This decision was also followed in Mettur Industries Ltd. v. CIT [1978] 114 ITR 439 (Mad), which lays emphasis on the fact that the addition to this account year after year was by way of lump sums and not on the basis of any ascertained amount. (c) The Kerala High Court in CIT v. Periakaramalai Tea Produce Co. Ltd. [1973] 92 ITR 65 has also taken the view that a fund created for payment on retirement of gratuity to the employees of a company is not for any commitment which has already arisen or payment of which has fallen due but is only a provision in regard to the gratuity which may have to be paid to the employees as and when the liabilities may arise in future and that the fu ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... gratuity reserve, therefore, as on the material date, being the first day of the previous year relevant to the three assessment years will have to be regarded as amounts having been set apart not designed to meet any known or existing liability and as such will have to be regarded as reserve." The Bombay High Court dissented from the Andhra Pradesh decision in Vazir Sultan [1974] 96 ITR 248 later referred to. (e) The Gujarat High Court has also taken the same view in CIT v.Joti Ltd.[1979] 112 ITR 973. The Tribunal in that case had found that the gratuity reserve was merely an amount kept back for future years without any reference to ascertained liability. There was no actuarial valuation and there was no case of a provision being made for anticipated known liability and, therefore, it was held to be in the nature of a reserve includible in the computation of the capital. The Gujarat High Court approved the view taken by the Tribunal referring to its own earlier decision in CIT v. Mafatlal Chandulal Co. Ltd. [1977] 107 ITR 489 (Guj). (f) The Calcutta High Court has taken the same view as in the above cases in three decisions, namely, CIT v. Burn and Co. Ltd. [1978] 114 ITR ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r the purpose of computing capital base as on the first day of the relevant accounting year. There is a clear distinction between an 'existing liability' and an 'existing demand'. For example, although a sum is required to be paid out but as to when it is required to be paid is not specified, and if a reserve has been created towards that liability, it can be called a reserve towards an 'existing liability', but it is not the same thing as a reserve towards an 'existing demand'. If this difference is borne in mind the distinction between an existing liability or 'debt owed' and an existing demand or a demand for payment is easily understandable. One can understand a case where an amount has been paid out even towards advance payment of tax as not being a reserve for the purpose of capital computation. As was held by the Gujarat High Court in the case of Rohit Mills Ltd. [1965] 58 ITR 854 or by the Madras High Court in the case of Nagammal Mills Ltd. [ 1974] 94 ITR 387 and the Calcutta High Court in the case of Indian Steel and Wire Products Ltd. [1958] 33 ITR 579, if an amount is paid out, certainly it cannot be available for the purpose of forming the capital base. As is the oft-q ..... X X X X Extracts X X X X X X X X Extracts X X X X
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