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TMI Blog1965 (10) TMI 24X X X X Extracts X X X X X X X X Extracts X X X X ..... out of capital and not out of taxed profits would not prevent it from being reserve as contemplated by sub-rule (1) of rule 2 of Schedule II of the Business Profits Tax Act? (3) Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the sum of $ 29,000,000 odd, $ 43,000,000 odd, $ 56,000,000 odd and $ 73,000,000 and odd for the respective years appearing in the balance-sheets of the assessee as " earned surplus " would be treated as a reserve within the meaning of sub-rule (1) of rule 2 of Schedule II of the Business Profits Tax Act ? " The High Court recorded answers in the affirmative on all the questions. The Commissioner of Income-tax has appealed to this court with special leave. The assessee-company is a non-resident. It was incorporated in the State of Delaware in the United States of America with the object of taking over the assets of two companies---Socony Vacuum Oil Company and Standard Oil Company (New Jersey). The capital of the assessee-company was $ 10,000,000 divided into 100,000 shares of the value of $ 100 each. On the date of acquisition the book values of the assets of two companies as recorded in their books of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... or its opinion. The provisions of the Business Profits Tax Act, 1947, which have a bearing on the questions raised in the reference to the High Court may first be summarised. By section 4 of the Act in respect of any business to which the Act applies, business profits tax is charged, levied and paid on the tax able profits during any accounting period at the rates specified in the Act. The expression " taxable profits " is defined in section 2(17) as the amount by which the profits during a chargeable accounting period exceed the abatement in respect of that period. " Abatement " is defined in section 2(1) (in so far as it is material) as meaning, in respect of any chargeable accounting period ending on or before the 31st day of March, 1947, a sum which bears to a sum equal to (a) in the case of a company, not being a company deemed for the purposes of section 9 to be a firm, six per cent. of the capital of the company on the first day of the said period computed in accordance with Schedule II, or one lakh of rupees, whichever is greater, and in respect of any chargeable accounting period beginning after the 31st day of March, 1947, such sum as may be fixed by the annual Finance ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ts to an account that is still generally called paid-in surplus arise in a number of circumstances which include : (a) where shares having a par value including the very low par value that has recently come into use, are issued and sold for cash or non-cash consideration in an amount in exess of par ... The occasion for the issue may be an initial or subsequent acquisition of property. Such a property acquisition may be the purchase of all or substantially all assets of another corporation as a going concern, or a merger by which such another corporation is absorbed by the surviving corporation, or a consolidation by which two or more corporations are absorbed by a new corporation created in the consolidation proceedings. Upon such a purchase of assets or in a merger or consolidation, the defensible value of the assets of the vendor or of the absorbed corporation or corporations may not be ' capitalized ' in its entirety, so that a paid-in surplus emerges from the transaction. " In Fletcher's Cyclopaedia Corporations, volume 19, paragraph 9237, the author has set out the prevailing method of carrying into the balance-sheet the amount of consideration received in excess of the par ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ual to the value of assets transferred. Where the value of assets transferred exceeds the par value, the difference may appropriately be regarded as " premium " according to the nomenclature used in India. Under the Companies Act, 1913, shares could be issued for cash or against transfer of property, and it is not claimed that under the statute law in the State of Delaware a different rule prevailed at the time when the assessee-company took over the assets of the transferor companies. The Indian Companies Act also places no restriction upon a company issuing shares for a consideration which exceeds the par value of the shares, and there is no evidence on the record that in the State of Delaware there is such a restriction. A share is not a sum of money : it represents an interest measured by a sum of money and made up of diverse rights contained in the contract evidenced by the articles of association of the company. In the absence of any restriction in the law of Delaware against the issue of shares otherwise than for cash, when shares are issued for consideration other than cash the value of the assets transferred in excess of the par value of shares issued would be regarded a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of shares. In the Companies Act, 1956 (1 of 1956), certain restrictions are imposed upon the application of premiums received on issue of shares by section 78. Shares could therefore be issued at a premium under the Act of 1913 and that appears to be recognised by the terms of section 78(3) of the Companies Act of 1956. It was found by the Tribunal that the amount entered in the balance-sheet as " Capital paid in Surplus " was retained in the business of the assessee-company, and the correctness of that view was not challenged before the High Court. The only argument advanced before the High Court on this part of the case was that shares could be said to be issued at a premium only when they were issued for cash in excess of the par value and not otherwise. But shares may be issued subject to express statutory provision to the contrary for money or services or in consideration of transfer of property, and there is no reason to think that a different rule applies when shares are issued at a premium. There is no provision in the Companies Act of 1913, which enacts a different rule, and it is not said that there is a statute in the State of Delaware which enacts a different rule. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hich it built up otherwise than out of profits of the business could be regarded as reserves for the purpose of rule 3 did not fall to be decided in that case. Under rule 2(1) reserves which in so far as they have not been allowed in computing the profits of the company enter into the computation of capital for the purpose of rule 2(1). This court observed in Century Spinning & Manufacturing Company's case : " Two essential characteristics must be present before the assessee can avail himself of the benefit of the rule, namely, that the amount should not have been allowed in computing the profits of the company for the purposes of the Income-tax Act and that it should be a reserve as contemplated by the rule. " Rule 2 does not expressly say that the reserve admissible in the computation of capital should be one built out of profits, and this court did not suggest that the rule contained such an implication. Observations made by Chagla C. J. in Century Spinning & Manufacturing Company's case at page 264 : " Therefore in order to determine the capital of the company for the purposes of this Act you have got to take the paid-up share capital of the company, then you have to add ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... features of the system of accounting obtaining in the United States of America. In the balance-sheets of companies the assets are balanced against liabilities, capital stock and surplus. In the company accounts it is usual to provide for specific or special reserves, but there is no allocation to a head called " General reserve " in the accounts. It is also well settled that the accounts of companies maintained under the American system are self-contained for each year. Under the system of accounting in vogue in India, after allocations are made to various purposes such as outgoings, expenses and reserves, specific and general, the balance is generally carried forward to the next year. The amount so carried forward gets merged into the account of the next year. If the capital and liabilities side exceeds the property and assets side, the difference is carried forward as loss in the next year. Under the American system of accounting, whatever remains on hand at the end of the year is entered on the liabilities, capital stock and surplus side as " earned surplus ". This was pointed out in First National City Bank v. Commissioner of Income-tax, where Kapur J., speaking for the court, ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s court in Century Spinning & Manufacturing Company Ltd. Counsel pointed out that in that case this court reversed the decision of the High Court of Bombay in which accumulated profits were regarded as reserves for the purpose of the Business Profits Tax Act. It is necessary carefully to scrutinise the facts in Century Spg. & Mfg. Company's case. For the account year ending December 31, 1945, the profits of the assessee-company amounted to Rs. 90,44,677. After providing for depreciation and taxation there remained an unallocated balance of Rs. 5,08,637 which was not allowed in computing the profits of the assessee for purpose of income-tax. In February, 1946, the directors recommended that out of that amount a sum of Rs. 4,92,426 be distributed as dividend and the balance of Rs. 16,211 be carried forward to the next year's account. The recommendation was accepted by the shareholders and dividend was shortly thereafter distributed. In computing the capital of the assessee-company on April 1, 1946, under the Business Profits Tax Act, 1947, the assessee claimed that Rs. 5,08,637 carried forward into the account of 1946 should be treated as " reserve " for the purpose of rule 2(1) of S ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... irectors recommend any dividend. The court observed : " In this case the directors while recommending dividend took no action to get aside any portion of this sum as a reserve or reserves. Indeed they never applied their mind to this aspect of the matter. The balance-sheet drawn up by the assessee as showing the profits was prepared in accordance with the provisions of the Indian Companies Act. These provisions also support the conclusion as to what is the true nature of a reserve shown in a balance-sheet. " The court was dealing in that case with the accounts of an Indian company, the balance-sheet of which was prepared according to the provisions of the Indian Companies Act, 1913. Regulation 99 of the First Schedule, Table A, required that reserves must be set apart before the directors recommended any dividend, but out of the profits of the company no amount was set apart towards reserves before the directors recommended payment of dividend to the shareholders. The identity of the amount remaining on hand at the foot of the profit and loss account was not preserved. It is on these facts that the court held that there was no allocation of the amount to reserve and from the me ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ontinuous future use in the business of the bank. In the case before us we have no such evidence on the record about the nature of the " earned surplus " account, but the manner in which the balance-sheets year after year are prepared and the general accountancy practice prevailing in the United States, suggest that there is specific allocation of the balance of profits at the end of each accounting year. The following table prepared from the balance-sheets and filed on behalf of the assessee-company (correctness of which has been accepted) clearly supports that view. -------------------------------------------------------------------------------------------------------------------------------------------------- Earnings Appropriations Earnings Fixed Year reinvested Net (made within year) reinvested assets (Earned surplus) profit (Earned surplus) (at cost) Opening balance Closing balance -------------------------------------------------------------------------------------------------------------------------------------------------- $ $ $ $ $ ---------------------------------------------------------------------------------------------------------------------------- ..... X X X X Extracts X X X X X X X X Extracts X X X X
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