PETITIONER:
VAZIR SULTAN TOBACCO CO. LTD. ETC. ETC.
Vs.
RESPONDENT:
COMMlSSIONER OF INCOME-TAX ANDHRA PRADESH, HYDERABAD
DATE OF JUDGMENT25/09/1981
BENCH:
TULZAPURKAR, V.D.
BENCH:
TULZAPURKAR, V.D.
VENKATARAMIAH, E.S. (J)
SEN, AMARENDRA NATH (J)
CITATION:
1981 AIR 2105 1982 SCR (1) 789
1981 SCC (4) 435 1981 SCALE (3)1483
CITATOR INFO :
RF 1986 SC 484 (13,17)
F 1986 SC1746 (6)
R 1986 SC1938 (5,13,14,16,17)
ACT:
Super Profits Tax Act, 1963 and Company's (Profits)
Sur-tax Act, 1964-Rule I of Second Schedule-Scope of-
"Provision" and "Reserve"-Distinction- A sum of money
transferred from current profits to general reserves-
Dividend paid from that fund-General reserve how calculated.
HEADNOTE:
The Super (Profits Tax) Act, 1963 and the Company's
(Profits) Sur-tax Act, 1964 (the scheme and main provisions
of both of which are almost identical) impose a special tax
on excess profits earned by companies. The special tax is
imposed in respect of so much of a company's "chargeable
profits" of the previous year as exceeded the "standard
deduction"- The term "chargeable profit" is defined to mean
the total income of an assessee computed under the Income
Tax Act, 1961 for any previous year and adjusted in
accordance with the provisions of that Act. "Standard
deduction" is determined by computing the capital of a
company in accordance with the rules laid down in the
schedule. The material part of rule I provides that before
any amount or sum qualifies for inclusion in capital
computation of a company two conditions are required to be
fulfilled namely: (i) that the amount or sum must be a
"reserve" and (b) that it must not have been allowed in
computing the company's profit for the purposes of Income
Tax Acts, 1922 or 1961.
ln their respective balance sheets, the assessees had
shown under the heading "current liabilities and provisions"
appropriations of large sums of money for taxation,
retirement gratuity and dividends and claimed that for the
purposes of super profits tax these sums should be regarded
as "other reserves" within the meaning of Rule 1 of Second
Schedule to the Act and that for the computation of capital
they should be taken into account.
Treating these sums as "provisions" and not as
"reserves", the Super Profits Tax officer determined the
capital and the standard deduction by excluding them from
the computation of the capital. He then levied super profits
tax on that portion of the chargeable profits of the
previous year as exceeded the standard deduction.
While the Appellate Assistant Commissioner upheld the
assessee's contention that these sums were "reserves" which
should be taken into account for computing their capital,
the Appellate Tribunal held that these were not "reserves"
within
790
the meaning of Rule l of the Second Schedule to the Act and
as such could not enter into capital computation.
On reference the High Court held that the sums set
apart were not "reserves and so should be excluded in the
computation of the capital for the purposes of levying the
super profits tax.
In Tax Reference no. 5 (a case under the Companies
(Profits) Sur-tax Act, 1964) the assessee transferred from
out of its current profits a large sum of money to the
general reserves and paid dividend to its shareholders from
out of the augmented general reserves. On the question
whether for computing the capital for the purpose of sur-tax
the general reserves should or should not be reduced by the
sum of dividend paid, the taxing authorities and the
appellate tribunal ignored this amount holding that it was
not a "reserve".
None of the items of appropriation either for taxation
or for retirement gratuity or for proposed dividend in the
assessees' cases had been allowed in computing their profits
under the Income Tax Act, 1961.
^
HELD: [per Tulzapurkar & Venkataramiah, JJ]
The expressions "reserve" and "provision" have not been
defined in the Act. Standard dictionaries, without making
any distinction between the two concepts, use them more or
less synonymously connoting the same idea. But since in the
context of the legislation a clear distinction between the
two is implied it is essential to know the exact connotation
of the two concepts and the distinction as known in
commercial accountancy. The rules for computation of capital
contained in the Second Schedule to the Act proceed on the
basis of the formula of capital plus reserve, a formula well
known in commercial accountancy. But since they occur in a
taxing statute applicable to companies only these
expressions will have to be understood in the sense or
meaning attributed to them by men of business, trade and
commerce and by persons interested in or dealing with
companies. Therefore, the meaning attached to these words in
the Companies Act, 1956 would govern their construction for
the purpose of these two enactments [800 C-H]
The broad distinction between the two expressions as
judicially evolved by this Court is that, while a
"provision" is a charge against the profits to be taken into
account against gross receipts in the profit and loss
account, a "reserve" is an appropriation of profits, the
asset or assets by which it is represented being retained to
form part of the capital employed in the business. [801 F]
C.l.T. v. Ccntury Spinning & Manufacturiag Co., 24 ITR
499 and Metal Box Company of India Ltd. v. Their Workmen, 73
lTR 67 followed.
The Companies Act, which enjoins upon the Board of
Directors of every company to lay before the annual general
meeting of its shareholders an annual balance sheet and a
profit and loss account, enumerates the separate heads that
should be shown in the balance sheet, two of these items
being "reserve' and "provision". The definitions of these
two expressions given in the Act show
791
that if any retention or appropriation of a sum falls within
the definition of A "provision" it can never be a "reserve".
But the converse is not true. If the retention or
appropriation is not a "provision" that is, if it is not
designated to meet depreciation, renewals or diminution in
value of assets or any known liability it is not
automatically a "reserve" and the question will have to be
decided having regard to the true nature and character of
the sum so retained or appropriated depending on several
factors, including the intention with which and the purposes
for which such retention or appropriation had been made.
[803 E-Fl
Having regard to the type of definitions of the two
concepts, if a particular retention or appropriation of a
sum falls within the expression "provision" then that sum
will have to be excluded from the computation of capital. If
the sum is in fact a "reserve" then it would be taken into
account for the computation of capital. [804 B-C]
Where the assessee had set apart a sum of money to meet
tax liability in respect of profits earned during an
accounting year, which liability was not quantified, such
setting apart for a known and existing liability, would be a
"provision" and could not be regarded as a "reserve". [806
A-C]
Kesoram Industries and Cotton Mills Ltd.v. Commissioner
of Wealth Tax (central) Calcutta, 59 ITR 767 followed.
But if provision for a known or existing liability is
made in excess of the amount reasonably necessary for the
purpose, such excess should be treated as reserve" and,
therefore, would be includible in capital computation. [806
E]
Since the assessee (in C.A. No. 860/73) had at no stage
of the proceedings before the Taxing Authorities or
Appellate Tribunal or the High Court raised a plea that the
provision made by it for taxation was in excess of the
amount reasonably necesssary for the purpose and that such
excess should be treated as a "reserve", the plea which
needs investigation into facts, could not be allowed to be
raised for the first time in appeal before this Court. [807
F]
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 employee 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 amount of gratuity payable is usually dependent on the
employee's wages at the time of G, determination of his
employment and the number of years of service put in by him
and the liability accrues and enhances with completion of
every year of service; but the company can work out on an
acturial valuation its estimated liability (i.e. discounted
present value of the liability under the scheme on a
scientific basis) and make a provision for such liability
not all at once but spread over a number of years. If by
adopting such scientific method any appropriation is made
such appropriation will constitute a provision representing
fairly accurately a known and existing liability for the
year in question; if however, an ad hoc sum
792
is appropriated without resorting to any scientific basis
such appropriation would also be a provision intended to
meet a known liability, though a contingent one, for, the
expression 'liability' occurring in cl. (7)(1)(a) of Part
III of Sixth Schedule to the Companies Act includes any
expenditure contracted for and arising under a contingent
liability: but if the sum so appropriated is shown to be in
excess of the sum required to meet the estimated liability
(discounted present value on a scientific basis) it is only
the excess that will have to be regarded as a reserve under
clause (7) (2) of Part III to the Sixth Schedule. [807 G.H;
808 A-D]
In the instant case although the assessee had urged
before the authorities below that different treatment for
the same item could not be given for purposes of income tax
assessment and super profits tax assessment the assessee did
not clarify by placing material on record as to whether
appropriation was based on any acturial valuation or whether
it was an appropriation of an ad hoc amount a which has a
vital bearing on the question, whether the appropriation
could be treated as a provision or reserve. In the absence
of proper material the question should be decided by the
taxing authorities whether the amount set apart and
transferred to gratuity reserve by the assessee company was
either a provision or a reserve and if the latter to what
extent. [812 C-E]
Standard Mills Co. Ltd. v. Commissioner of Wealth-Tax,
Bombay, 63, I.T.R.470 & Workmen of William Jacks & Co. Ltd.
v. Management of Jacks & Co.Ltd; Madras. [1971] Supp. S.C.R.
450 followed.
Southern Railway of Peru Ltd. v. Owen [1957] A.C. 334
referred to.
The appropriations of an amount by the Board of
Directors by way of providing for proposed dividend would
not constitute 'provision', 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 recommendation much less on the relevant date after the
first day of the previous year relevant to the assessment
year in question. This by itself would not convert the
appropriations into "reserves". [813 E-F]
The tests and guidelines laid down by this Court in
this respect are: (1) the true nature and character of the
appropriation must be determined with reference to the
substance in the matter, which means that one must have
regard to the intention with which and the purpose for which
appropriation has been made such intention and purpose being
gathered from the surrounding circumstances. A mass of
undistributed profits cannot automatically become a reserve.
Some body 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 a general reserve or a specific
reserve; (2) the surrounding circumstances should make it
apparent that the amount so earmark ed or set apart is in
fact a reserve to be utilised in future for a specific
purpose on a specific occasion; (3) 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 of dividend in the same year would run counter
to any intention of making that amount a reserve, (4) the
nomenclature accorded to any particular fund which is set
apart from out of the profits would not be material
793
Or decisive of the matter; and (5) if any amount set apart
from out of the profits A is going to make up capital fund
of the assessee and would be available to the assessee for
its business purposes it would become a reserve liable to be
included in the capital computation of the assessee under
that Act. [815 F-H, 817 G]
The relevant provisions of the Companies Act clearly
show that creating reserves out of the profits is a stage
distinct in point of fact and anterior in point of time to
the stage of making recommendation for payment of dividend
and the scheme of the provisions suggests that appropriation
made by the Board of Directors by way of recommending a
payment of dividend cannot in the nature of things be a
reserve. [818 F-G]
Judged in the light of the above guidelines the
appropriations made by the Directors for proposed dividend
in the case of the concerned assessee companies did not
constitute 'reserves' and the concerned amounts so set apart
would have to be ignored or excluded from capital
computation. [818 H]
Standard Mills Co. Ltd. v. Commissioner of Wealth-tax
Bombay, 63 I.T.R.470, Metal Box Co. Of India Ltd. v. Their
Workmen, 73 ITR 67, First National City Bank v. Commissioner
of Income-Tax, 42 ITR 67 & Commissioner of Income- tax
(Central), Calcutta v. Standard Vacuum oil Co., 59 ITR 685
followed.
Although under the Companies Act it is open to the
Directors to recommend and the share-holders to approve
payment of dividend from the current year's profits or from
the past year's profits and on transfer of a portion of the
current year's profit to the general reserve the augmented
general reserve becomes a congolmerate fund, having regard
to the natural course of human conduct it is not difficult
to predicate that dividends would ordinarily be paid out
from the current income rather than from the past savings,
unless the directors in their report expressly or
specifically state that payment of dividends would be made
from the past savings. From the commercial point of view, if
any amount is required for incurring any expenditure or
making any disbursement like distribution of dividends in a
current year, ordinarily the same will come out of the
current income of the company if it is available and only if
the sum is insufficient then the past savings will be
resorted to for the purpose of incurring that expenditure or
making that disbursement. Such a course would be in accord
with the common sense point of view. [822 C-F]
In the absense of express indication to the contrary
the normal rule for a commercial concern would be to resort
to current income rather than past savings while incurring
any expenditure or making any disbursement. [822 H]
Commissioner of Income-Tax, Bombay City-l v. Bharat
Bijlee Ltd. 107 ITR 30; & Commissioner of Income-Tax, Bombay
City-ll v. Marrior (India) Ltd. 120 ITR Sl 2 approved.
[per A.N. Sen, J.]
The amount set apart for payment of any dividend
recommended by the Board of Directors is not an amount set
apart for meeting a known or existing
794
liability and cannot be considered to be a "reserve" within
the meaning of the Act for the purposes of computation of
the capital of the company. [832 F]
The Companies Act, 1956 provides for the preparation of
annual balance sheet in the prescribed form and laying it
before the shareholders at the annual general meeting.
Regulation 87, Table A in Schedule I contemplates that the
Board may set aside out of the profits of the company
certain sum as "reserve" before dividend is recommended by
it. The amount recommended by the Board for payment of
dividend is shown in the balance sheet under the head
"provision" and not under any head of "reserve". The true
nature and character of the sum so set apart must be
determined with regard to the substance of the matter which
in this case is that the sum set apart was never intended to
constitute a "reserve' of the company. [833 F, 834G]
In law the liability for payment of dividend arises
only when the share-holders accept the recommendations made
by the Directors. Till then it is open to the Directors to
modify or withdraw their recommendation before it is
accepted by the shareholders and it is equally open to the
share-holders not to accept the recommendation in its
entirety. Even so, for business purposes when the Directors
make any recommendation for payment of dividend and set
apart any amount for this purpose the Directors intend to
make a provision and do not create any reserve, as Directors
know that their recomendation is generally accepted by the
shareholders as a matter of course. Therefore any amount set
apart for this purpose is understood by persons interested
in company matters and in dealing with companies to mean a
provision for the payment of dividend to the shareholders
and is not understood to constitute a "reserve". [832 C-F]
Commissioner of lncome-tax Bombay City v. Century
Spinning and Manufacturing Co. Ltd. [1953] 24 I.T.R. 499,
Commissioner of Income Tax v. Standard Vaccum oil Co.,
[1966] 59 I.T.R. 685, Metal Box Co. Of Ltd. v. Their
Workmen, [1963] 73 I.T.R, 53, Commissioner of Income-tax v.
Mysore Electrical Industries Ltd., [1971] 80 l.T.R. 567 and
Kesho Ram Industries and Cotton Mills Ltd v.Commissioner of
Wealth Tax (Central), Calcutta, [1966] 59 I.T.R. 767
referred to.
JUDGMENT:
CIVIL APPELLATE JURISDICTION: Civil Appeal No. 860 of
1973.
From the judgment and order dated the 1st September,
1972 of the Andhra Pradesh High Court at Hyderabad in R.C.
No. 10 of 1971.
AND
Civil Appeal No. 1614 (NT) of 1978.
Appeal by Special Leave from the judgment and order
dated the 26th July, 1976 of the Calcutta High Court in l.T.
Reference No.454 of 1974.
AND
Review Petition No. 57 of 1980.
795
IN
Special Leave Petition (Civil) No. 4602 of 1977
From the judgment and order dated the 11th June, 1974
of the Calcutta High Court in I.T. Reference No. 195 of
1969.
AND
Tax Reference Case Nos. 2 and 3 of 1977.
Income-tax Reference under section 257 of the Income-
tax Act, 1961 drawn up by the Income-tax Appellate Tribunal,
Bombay Bench ‘B’ in R.A. Nos. 1223 and 1224 (Bom.) of 1972-
73 (I.T. A. Nos. 24 and 25 (Bom.) of 1971-72.
AND
Tax Reference Case No. S of 1978.
Income Tax Reference under section 257 of the Income
Tax Act, 1961 made by the Income Tax Appellate Tribunal,
Bombay Bench “D” in R.A. No. 225 (Bom.) of 1977-78 arising
out of S.T.A.No. 36 (Bombay) 1 1976-77.
A. Subbarao and Y.V. Anjaneyulu for the appellant in
Civil Appeal No. 860/73. E
V.S. Desai, Dr. Debi Pal, Praveen Kumar and Anil Kumar
Sharma for the Appellant in C.A. 1614 of 1978 and for the
Petitioner in Review Petition No. 57/80.
K.G. Haji and R.J. John for the Appellant in Tax
Reference Case Nos. 2 and 3 of 1977.
S.E. Dastur, S.N. Talwar and R.J. John for the
Appellant in Tax Reference Case No. 5 of 1978.
S.T. Desai, J. Ramamurthi and Miss A. Subhashini for
the Respondent in Civil Appeal No. 860/73.
Miss A. Subhashini for the Respondent in Civil Appeal
No.1614 of 1978
S.C. Manehanda and Miss A. Subhashini for the
Respondent in Tax Reference Nos. 2 and 3 of 1977.
796
S.C. Manchanda, Anil Dev Singh and Miss A. Subhashini
for the Respondent in Tax Reference Case No. 5/1978.
S P. Mehta and K.J. John for the Intervener.
Dr. Debi Paul and K.J. John for the Intervener in Tax
Reference Case No. 5/1978.
The following Judgments were delivered:
TULZAPUKKAR, J. In these Civil Appeals and Tax
Reference Cases certain common questions of law arise for
our determination and hence all these are disposed of by
this common judgment. The common questions raised are
whether amounts retained or appropriated or set apart by the
concerned assessee company by way of making provision (a)
for taxation, (b) for retirement gratuity and (c) for
proposed dividends from out of profits and other surpluses
could be considered as “other reserves” within the meaning
of Rule I of the Second Schedule to the Super Profits Tax
Act, 1963 (or Rule 1 of the Second Schedule to the Company’s
(Profits) Sur-tax Act, 1964) for inclusion in capital
computation of the Company for the purpose of levying super
profit tax ? The first three matters concerning Vazir Sultan
Tobacco Co. Ltd; Hyderabad, Ballarpur lndustries, Ltd; and
M/s. Bengal Paper Mills Co. Ltd; Calcutta arise under the
Super Profits Tax Act, 1963 while the the Tax Reference
Cases concerning M/s. Echjay Industries Pvt. Ltd. and Hyco
Products Pvt. Ltd. Bombay arise under the Companies
(Profits) Sur-tax Act.1 964.
Since Civil Appeal No. 860 of 1973 (Vazir Sultan
Tobacco Company’s case) is comprehensive and comprises all
the three items of appropriation it will be sufficient if
the facts in this case are set out in detail so as to
understand how the questions for determination arise in
these matters. Vazir Sultan Tobacco Co. Ltd. was an assessee
under the Super (Profits) Tax Act, 1963. For the assess-
ment year 1963-64, for which the relevant accounting period
was the year which ended 30th September, 1962, for computing
the chargeable profits of that year for the purpose of levy
of super profits tax under the Act, the assessee company
claimed that the appropriations of a) Rs. 33,68,360 for
taxation, (b) Rs. 9,08,106 for retirement gratuity and (c)
Rs. 18,41,820 for dividends (all of which items were shown
under the heading ‘current liabilities and provisions’ in
the concerned balance-sheet as at 30th Sept. 1962) should be
regar-
797
ded as “other reserves” within the meaning of Rule 1 of
Second A Schedule to the Act and be included while
determining its capital. The Super Profits Tax officer
rejected the assessee’s contention as in his opinion all
these items were “provisions ‘ and not “reserves” and as
such these had to be ignored or excluded from the capital
computation of the assessee company and on that basis he
determined the capital, and the standard deduction and
levied super profits tax on that portion of the chargeable
profits of the previous year which exceeded the standard
deduction. In the appeal preferred by the assessee company
against the assessment, the Appellate Commissioner upheld
the assessee’s contentions and held that those items were
“reserves” and took them into account while computing the
capital of the assessee company. In the further appeal
prefer- red by the Super Tax officer, the Income Tax
Appellate Tribunal accepted the Department’s contention and
held that these were not “reserves” within the meaning of
Rule I of the Second Schedule to the Act and as such these
could not enter into capital computation of the assessee
company. In the Reference that was made under section 256(1)
of the Income Tax Act, 1961 read with s. 10 of the Super
Profits Tax Act at the instance of the assessee company the
following question of law was referred to the Andhra Pradesh
High Court for its opinion:
“Whether on the facts and in the circumstances of
the case the provisions (a) for taxation Rs. 33,68,360,
(b) for retirement gratuity Rs. 9,08,106 and (c) for
dividends Rs. 18,41,820, could be treated as ‘reserves’
for computing the capital for the purpose of super
profits tax under Second Schedule to the Super Profits
Tax Act, 1963 for the assessment year 1963-64 ?” F
The High Court on a consideration of several
authorities answered the question in respect of the three
items in favour of the Revenue and against the assessee
company and held that the three sums so set apart by the
assessee company in its balance-sheet were not “reserves”
and had to be excluded in the computation of its capital for
the purpose of levying super profits tax payable on the
chargeable profits tor the relevant accounting year. It is
this view of the High Court that is being challenged by the
assessee company in the Civil Appeal No. 86() of 1973 before
us.
In Civil Appeal No. 1614/1978 (Ballarpur Industries Ltd
) and Review Petition No. 57 of 1980 (M/s. Bengal Paper
Mills Co. Ltd.)
798
We are concerned with only two items of appropriation being
(a) provision for taxation and (b) provision for proposed
dividend and in each one of these cases the Calcutta High
Court had taken the view that these two items do not
constitute “reserves” and as such have to be ignored while
computing the capital of the assessee company.
In Tax Reference Case Nos. 2 and 3 of 1977 (M/s Echjay
Industries Pvt. Ltd.)-a case under Companies (Profits)
Surtax Act, 1964, we are concerned with two items of
appropriation being (a) provision for taxation (b) provision
for proposed dividend for the two assessment years 1969-70
and 1970-71 and in each of the years the Taxing Authorities
as also the Income Tax Appellate Tribunal Bombay have taken
the view that these appropriations did not constitute “other
reserves” within the meaning of Rule I of the Second
Schedule to the Companies (Profit) Surtax Act, 1954 and as
such were not includible in the capital computation of the
assessee company but in view of a divergence of opinion
between the different High Courts on the point, the Tribunal
has at the instance of the assessee company made a direct
Reference to this Court under s. 257 of the Income Tax Act,
1961 read with s. 18 of the Companies (Profits) Surtax Act,
1964.
In Tax Reference Case No. 5 of 1978 (Hyco Products
Pvt.Ltd.)-also a case under Companies (Profits) Surtax Act,
1964 the same question pertaining to dividend alone but in a
different form arose for consideration before the Taxing
Authorities and the Income Tax Appellate Tribunal. It was
not a case of ‘proposed dividend’ but the assessee company
after transferring Rs. 29,77,000 out of the current year’s
profit amounting to Rs. 61,03,382 to General Reserves, paid
out of Rs. 3,10,450 as dividend to its share-holders from
such augmented General Reserves and the question was whether
while computing the capital of the assessee-company for the
purpose of levy of surtax the General Reserves should or
should not be reduced by the aforesaid sum of Rs. 3,10,450 ?
In other words, the question was whether the amount of Rs.
3,10,450 could not form part of the General Reserves on the
relevant date (being 1.1. 1973) for the computation of the
capital ? The Taxing Authorities as well as the Appellate
Tribunal Bombay held that the said amount of Rs. 3,10,450
had to be ignored for the purpose of computation of capital
for surtax purposes because it was not a reserve. The
assessee company has challenged this view of the Tribunal
before us in this direct Reference made to this Court under
s. 257 of the
799
Income Tax Act, 1961 read with s. 18 of the Companies’
(Profits) A Surtax Act, 1964.
It may be stated that the scheme and the main
provisions of the two concerned enactments are almost
identical, the object of both these enactments being the
imposition of a special tax on excess profits earned by
companies. Under Section 4 of the 1963 Act, which is the
charging provision, there shall be charged on every company
for every assessment year commencing on and from 1st April,
1963, a tax, called the super profits tax, in respect of so
much of 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 Income Tax Act, 1961, for any
previous year and adjusted in accordance with the provisions
of First Schedule, while Section 2(9) defines the expression
“standard deduction” to mean an amount equal to six per cent
of the capital of company as computed in accordance with the
provisions of the Second Schedule, or an amount of Rs.
50,000 whichever is greater. In order to D determine
“standard deduction” it becomes necessary to compute capital
of the company in accordance with the rules laid down in the
Second Schedule and rule 1 is relevant for our purposes, the
material portion whereof runs 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, credited under the proviso (b) to Clause (vi-
b) of sub-section (2! of sec. 10 of the Indian
Income Tax Act, 1922 or under sub section (3) of
sec. 34 of the Income Tax Act, 1961, and of its
other reserves in so far as the amounts credited
to such other reserves have not been allowed in
computing its profits for the purposes of the
Indian Income Tax Act, 1922 or the Income Tax Act,
1961 .. “
It will be clear from the aforesaid provision of rule 1
that before any amount or sum qualifies for inclusion in
capital computation of a company two conditions are required
to be fulfilled-(a) that the amount or sum must be a
“reserve” and (b) the same must not have been allowed in
computing the company’s profits for the purposes of the 1922
Act or the 1961 Act. That none of the items
800
of appropriation either for taxation or for retirement
gratuity, or for proposed dividend in the concerned
assessees’ case had been allowed in computing the assessee’s
profits under the 1961 Act has not been disputed; in other
words the second condition indicated above has been
satisfied. The question is whether any of these items could
be treated as or falls within the expression “other
reserves” occurring in the said rule.
The expression ‘reserve’ has not been defined in the
Act and therefore one would be inclined to resort to its
ordinary natural meaning as given in the dictionary but it
seems to us that the dictionary meaning, though useful in
itself, may not be sufficient, for, the dictionaries do not
make any distinction between the two concepts ‘reserve’ and
‘provision’ while giving their primary meanings whereas in
the context of the legislation with which we are concerned
in the case a clear distinction between the two is implied.
According to the dictionaries (both oxford and Webster) the
applicable primary meaning of the word ‘reserve’ is: “tc,
keep for future use or enjoyment; to set apart for some
purpose or end in view; to keep in store for future or
special use; to keep in reserve”, while ‘provision’
according to Webster means: “something provided for future.”
In other words according to the dictionary meanings both the
words are more or less synonymous and connote the same idea.
Since the rules for computation of capital contained in the
Second Schedule to the Act proceed on the basis of the
formula of capital plus reserves-a formula well-known in
commercial accountancy, it becomes essential to know the
exact connotation of the two concepts ‘reserve’ and
‘provision’ and the distinction between the two as known in
commercial accountancy. Besides, though the expression
‘reserve’ is not defined in the Act, it cannot be forgotten
that it occurs in a taxing statute which is applicable to
companies only and to no other assessable entities and as
such the expression will have to be understood in its
ordinary popular sense, that is to say, the sense or meaning
that is attributed to it by men of business, trade and
commerce and by persons interested in or dealing with
companies. Therefore, the meanings attached to these two
words in the provisions of the Companies Act 1956 dealing
with preparation of balance-sheet and profit and loss
account would govern their construction for the purposes of
the two taxing enactments. We might mention here that in
C.l.T. v. Century Spinning and Manufacturing Company (1)
this Court after referring to the dictionary
801
meaning of the expression ‘reserve’ observed: “what is the
true A nature and character of the disputed sum (sum
allegedly set apart) must be determined with reference to
the substance of the matter” and went on to determine the
true nature and character of the disputed sum by relying
upon the provisions of the Indian Companies Act 1913, the
form and the contents of the balance-sheets required to be
drawn up and Regulation 99 in Table A of the 1st Schedule.
The distinction between the two concepts of ‘reserve’
and ‘provision’ is fairly well-known in commercial
accountancy and the same has been explained by this Court in
Metal Box Company of India Ltd. v. Their Workmen (1) thus:
“The distinction between a provision and a reserve
is in commercial accountancy fairly well known. Provi-
sions made against anticipated losses and contingencies
are charges against profits and therefore, to be taken
into account against gross receipts in the P. and 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. (See Spicer and
Pegler’s Book-keeping and Accounts, 15th Edition, page
42)”.
In other words the broad distinction between the two is that
whereas a provision is a charge against the profits to be
taken into account against gross receipts in the P and L
account, a reserve is an appropriation of profits, the asset
or assets by which it is represented being retained to form
part of the capital employed in the business. Bearing in
mind the aforesaid broad distinction we will briefly
indicate how the two concepts are defined and dealt with by
the Companies Act, 1956.
Under s. 210 of the Companies Act, 1956 it is incumbent
upon the Board of Directors of every company to lay before
the annual general meeting of its share-holders (a) the
annual balancesheet and (b) the profits and loss account
pertaining to the previous
802
financial year. Section 211(1) provides that every balance-
sheet of a company shall give a true and fair view of the
state of affairs of the company as at the end of the
financial year and shall, subject to the provisions of this
section, be in the form set out in Part I of Schedule VI, or
near thereto as circumstances admit or in such other from as
may be approved by the Central Government either generally
or in any particular case, while s. 211(2) provides that
every profit and loss account of a company shall give a true
and fair view of the profit or loss of the company for the
financial year and shall, subject as aforesaid, comply with
the requirements of Part Ir of r Schedule VI, so far as they
are applicable thereto. In other words the preparation of
balance-sheet as well as profit and loss account in the
prescribed forms and laying the same before the share-
holders 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 Surpluses’ and ‘current
liabilities and provisions’ and under the sub-head
‘reserves’ different kinds of reserves are indicated and
under sub-head ‘provisions’ different types of provisions
are indicated; Part III is the interpretation clause setting
out the definitions of various expressions occurring in
Parts I and Il and the expressions ‘reserve’, ‘provision’
and ‘liability’ have been defined in cl. 7 thereof. Material
portion of cl. (7) of Part III runs as under:
“(1) For the purposes of Parts I and II of this Sche-
dule, unless the context otherwise requires:
(a) the expression “provision” shall, subject to sub.
cl. (2) of this clause mean any amount written off
or retained by way of providing for depreciation,
renewals or diminution in value of assets, or
retained by way of providing for any known
liability of which the amount cannot be determined
with substantial accuracy:
(b) the expression “reserve” shall not, subject as
aforesaid, include any amount written off or
retained by way of providing for depreciation,
renewals or diminution in value of assets or
retained by way of providing for any known
liability;
(c) x x x x x x x x x
803
and in this sub-clause the expression “liability” shall
include A 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 a ‘provision’.”
On a plain reading of cl. 7(1) (a) and (b) and cl. 7(2)
above it will appear clear that though the term ‘provision’
is defined positively by specifying what it means the
definition of ‘reserve’ is negative in form and not
exhaustive in the sense that it only specifies certain
amounts which are not to be included in the term ‘reserve’.
In other words the effect of reading the two definitions
together is that if any retention or appropriation of a sum
falls within the definition of ‘provision’ it can never be a
reserve but it does not follow that if the retention or
appropriation is not a provision it is automatically a
reserve and the question will have to be decided having
regard to the true nature and character of the sum so
retained or appropriated depending on several factors
including the intention with which and the purpose for which
such retention or appropriation has been made because the
substance of the matter is to be regarded and in this
context the primary dictionary meaning of the term ‘reserve’
may have to be availed of. But it is clear beyond doubt that
if any retention or appreciation of a sum is not a
provision, that is to say, if it is not designated to meet
depreciation, renewals or diminution in value of assets or
any known liability the same is not necessarily a reserve.
We are emphasising this aspect of the matter because during
the hearing almost all counsel for the assessees strenuously
contended before us that once it was shown or became clear
that the retention or appreciation of a sum out of
804
profits and surpluses was for an unknown liability or
for a liability which did not exist on the relevant date it
must be regarded as a reserve. The fallacy underlying the
contention becomes apparent if the negative and non-
exhaustive aspects of the definition of reserve are borne in
mind. Having regard to type of definitions of the two
concepts which are to be found in cl. 7 of Part. III the
proper approach in our view, would be first to ascertain
whether the particular retention or appropriation of a sum
falls within the expression ‘provision’ and if it does then
clearly the concerned sum will have to be excluded from the
computation of a capital, but in case the retention or
appropriation of the sum is not a provision as defined the
question will have to be decided by reference to the true
nature and character of the sum so retained or appropriated
having regard to several factors as mentioned above and if
the concerned sum is in fact a reserve then it will be taken
into account for the computation of capital.
Having thus indicated the proper approach to be
adopted, we shall proceed to deal with the three items of
appropriation being (a) provision for taxation, (b)
provision for retirement gratuity and (c) provision for
proposed dividends in the case of concerned assessee
companies in these Appeals and Tax Reference Cases.
Dealing first with the item of appropriation by way of
provision for taxation, which arises in Civil Appeal No.
860/1973 (Vazir Sultan Tobacco Company), Civil Appeal No.
1614 (NT)/ 1978 (Ballarpur Industries Ltd;) Review Petition
No. 50/1980 (M/s. Bengal Paper Mills Co. Ltd.) and Tax
Reference Cases Nos. 2 & 3/1977 (M/s Echjay Industries Pvt.
Ltd;)-the common question is whether the concerned amounts
appropriated or set apart by these assessee-companies from
out of the profits and other surpluses by way of making
provision for taxation constitute a provision or a reserve
on the relevant date, being the first day of the previous
year relevant to the assessment year in question ? Taking
Vazir Sultan Tobacco Company’s case as an illustration, for
the assessment year 1963-64 the relevant accounting period
was the year which ended on September 30, 1962; under Rule I
of the Second Schedule to the Super Profits Tax Act, the
first day of the previous year would be october 1, 1961 and.
therefore, the balance-sheet of that company as on September
30, 1961 and the profits and loss account which ended on
September 30, 1961 would be relevant. It cannot be disputed
that on the expiry of September 30, 1961, the assessee
company incurred the taxation liability in respect of the
profits
805
which it had earned during that year, though the exact
amount of such liability could not be determined with
substantial accuracy at that time and the same would have to
be ascertained by reference to rate of taxes applicable to
that year. The liability for taxation having thus arisen on
the expiry of the last day of the year, the setting apart of
the sum of Rs. 33,68,360 by the Board of Directors will have
to be regarded as a provision for a known and existing
liability, the quantification whereof bad to be done later.
On principle, therefore, it seems to us clear that the item
of Rs. 33,68,360 which had been set apart by the Board of
Directors for taxation must be regarded as a provision and
cannot be regarded as a reserve. Similar would be the
position in regard to the appropriations for taxation made
by the other assessee-companies mentioned earlier.
In this context a reference to this Court’s decision in
the case of Kesoram Industries and Cotton Mills Ltd. v.
Commissioner of Wealth Tax (Central) Calcutta(‘) would be
useful. In that case the question was whether a certain
amount which had been set apart as provision for payment of
income-tax and super tax was a “debt owed” within the
meaning of s. 2(m) of the Wealth-Tax Act, 1957, as on March
31, 1957 which was the valuation date and as such was
deductible in computing the net wealth of the appellant
company. In its balance-sheet for the year ending March 31,
1957 the appellant company had shown a certain amount as
provision for payment of income-tax and super-tax in respect
of that year of account and this Court took the view that
the expression “debt owed” within the meaning of s. 2(m) of
the Wealth-Tax Act, 1957 could be defined as the liability
to pay in presenti or in futuro an ascertainable sum of
money and that the liability to pay income-tax was a present
liability though the tax became payable after it was
quantified in accordance with ascertainable data; that there
was a perfected debt on the last date of the accounting year
and not a contingent liability. The Court further observed
that the rate was always easily ascertainable; that if the
Finance Act was passed, it was the rate fixed by that Act;
if the Finance Act was not yet passed, it was the rate
proposed in the Finance Bill pending before the Parliament
or the rate in force in the preceding year whichever was
more favourable to the assessee and that all the ingredients
of a “debt” were present and it was a present liability of
an ascertainable amount and that, therefore, the amount of
provision for payment of income-tax and super-tax in respect
of the year of account ending March 31, 1957 was a “debt H
806
owed” within the meaning of s. 2(m) on the valuation date,
namely March 31, 1957 and was as such deductible in
computing the net wealth. 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 i n capital computation.
Counsel for the assessee company in Vazir Sultan
Tobacco Company’s case, however, attempted to raise a
further plea that the provision for taxation in the sum of
Rs. 33,68,360 was an excess provision in the sense it was in
excess of the amount which was reasonably necessary for the
purpose of taxation and, there ore, the excess should be
treated as a reserve and not a provision and in this behalf
reliance was placed on cl. (7) (2) of Part III of Schedule
VT and three decisions-of the Madras High Court Commissioner
of Income-tax Madras v. Indian Steel Rolling Mills Ltd.(l)
of the Himachal Pradesh High Court in Hotz Hotels Pvt. Ltd.
v. Commissioner of Income Tax, Haryana, H.P. and Delhi(2)
and of Allahabad High Court in Commissioner of Income-Tax,
Delhi v. Modi Spinning and Weaving Mills(3). There could be
no dispute about the principle that if provision for a known
or existing liability is made in excess of the amount that
would be reasonably necessary for the purpose 13: the excess
shall have to be treated as a reserve and, therefore, would
be includible in the capital computation but no such case
was made out by the assessee company at any stage of the
assessment proceedings either before the Taxing Authorities
or even before the Tribunal or the High Court and in the
absence of any such plea having been raised at any stage of
the proceedings it will not be proper for this Court to
allow the assessee company to raise such a plea, which will
need investigation into facts, for the first time in its
appeal before this Court. The contention is, therefore,
rejected. Dealing next with the item of appropriation made
for retirement gratuity, which arises only in Civil Appeal
No. 860/1973 (Vazir Sultan Tobacco Co.) the question is
whether the sum of Rs. 9,O8,106 appropriated or set apart by
the assessee company from out of its profits and other
surpluses by way of providing for retirement gratuity is a
provision or a reserve on the relevant date,
807
viz. 1.10.1961 ? Counsel for the assessee-compaoy vehemently
urged before us that this appropriation had not been allowed
as a deduction in the income-tax assessment proceedings of
the company for the relevant assessment year on the ground
that it was in the nature of a reserve and the entire sum,
minus the actual payments, was added back to the income and
profits of the assessee-company and if that be so, in the
super profit-tax assessment it cannot be treated as a
provision and excluded from capital computation. According
to him there could not be two different treatments for the
same item in income-tax assessment and super profit tax
assessment. He pointed out that this contention was
specifically urged in the appeal before the Appellate
Assistant Commissioner but was wrongly rejected. He further
submitted that no actuarial valuation had been undertaking
but ad hoc amount was appropriate or transferred to gratuity
reserve and as such the same should have been treated as a
reserve and included in capital computation. On the other
hand, counsel for the Revenue seriously disputed the last
submission and contended that it was never the case of the
assessee-company either before the Taxing Authorities or
before the Tribunal or before the High Court that the
appropriation was or an ad hoc sum without undertaking any
actuarial valuation. It must be observed that whereas the
assessee-company did urge a contention before the lower
authorities that different treatments for the same item
could not be given for purpose of income-tax assessment and
super profit-tax assessment, the assessee company did not
clarify by placing material on record as to whether the
appropriation of the amount was based on any actuarial
valuation or whether it was an appropriation of an ad hoc
amount an aspect which, as we shall presently point out, has
a vital bearing on the question whether the appropriation
could be treated as a provision or a reserve. In the absence
of proper material touching this vital aspect, we are
afraid, the issue in question will have to be remanded to
the Taxing Authorities through the Tribunal for disposal in
the light of the well settled principles in that behalf,
which we shall presently indicate.
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 amount of gratuity payable is usually dependent on the
emp-
808
loyee’s wages at the time of determination of his employment
and the number of years of service put in by him and the
liability accrues and enhances with completion of every year
of service; but the company can work out on an actuarial
valuation its estimated liability (i.e. discounted present
value of the liability under the scheme on a scientific
basis) and make a provision for such liability not all at
once but spread over a number of years. It is clear that if
by adopting such scientific method any appropriation is made
such appropriation will constitute a provision representing
fairly accurately a known and existing liability for the
year in question; if, however, an ad hoc sum is appropriated
without resorting to any scientific basis such appropriation
would also be a provision intended to meet a known
liability, though a contingent one, for, the expression
‘liability’ occurring in cl. (7) (1) (a) of Part III of the
Sixth Schedule to the Companies Act includes any expenditure
contracted for and arising under a contingent liability; but
if the sum so appropriated is shown to be in excess of the
sum required to meet the estimated liability (discounted
present value on a scientific basis) it is only the excess
that will have to be regarded as a reserve under cl. (7) (2)
of Part III to the Sixth Schedule.
In the above context we might refer to one English case
decided by the House of Lords and two or three decisions of
this Court, which seem to lead to aforesaid propositions. In
Southern Railway of Peru Ltd. v. Owen(1) an English Company
operating a railway in Peru was, under the laws of that
country, liable to pay its employees conpensation on the
termination of their services either by dismissal or by
notice or on such termination by death or efflux of
contractual time. The compensation so paid was an amount
equivalent to one month’s salary at the rate in force at the
date of determination for every year of service. In the
computation of taxable income under the Income-tax Act 1918,
the company claimed to be entitled to charge against each
year’s receipts the cost of making provision for the
retirement payments which would ultimately be thrown on it,
calculating the sum required to be paid to each employee if
he retired without forfeiture at the close of the year and
(; setting aside the aggregate of what was required in so
far as the year had contributed to the aggregate. The House
of Lords rejected the deductions on the ground that in
calculating the deductions the company had ignored the
factor of discount. But, their Lordships recognised the
principle that the company was entitled to charge, against
each year’s receipts, the cost of making the
809
provision for the retirement which would ultimately be
payable as the company had the benefit of the employee’s
services during that year provided the present value of the
future payments could be fairly estimated. Lord MacDermott
observed at page 345 as follows:
“…. as a general proposition it is, I think
right to say that, in computing his taxable profits for
a particular year, B a trader, who is under a definite
obligation to pay his employees for their services in
that year an immediate payment and also a future
payment in some subsequent year, may properly deduct,
not only the immediate payment but the present value of
the future payment, provided such present value can be
satisfactorily determined or fairly estimated.”
In Standard Mills Co. Ltd. v. Commissioner of Wealth-
Tax, Bombay (1) the question for decision was whether an
estimated liability under gratuity schemes framed under
industrial awards amounted to ‘debts’ and could be deducted
while computing the net wealth of the assessee-company under
the Wealth Tax Act. This Court held in view of the terms of
s. 2 (m) of that Act, that as the liability lo pay gratuity
was not in praesenti but would arise in future on
determination of the service, i. e. On the retirement, death
or termination, the estimated liability under the schemes
would not be a ‘debt’ and, therefore, could not be deducted
while computing the net wealth. The House of Lords decision
in the case of Southern Rly. Of Peru Ltd. (supra) was
distinguished by this Court as having no relevance to the
question before it on the ground that the House of Lords in
that decision was concerned in determining the deductibility
of the present value of a liability which may arise in
future in the computation of taxable income for the relevant
year under the income-tax laws. It will thus appear that
this Court was of the view that though such a liability is a
contingent liability and, therefore, not a ‘debt’ under s.
2(m) of the Wealth-Tax Act it would be deductible under the
Income Tax Act while computing the taxable profits; in other
words different considerations would apply to cases arising
under the Wealth-Tax Act and the Income-Tax Act.
In Matal Box Co’s case (supra) this Court was concerned
with the nature of liability under a scheme of gratuity in
the context of the Payment of Bonus Act, 1965 and the
question related to a sum
810
of Rs. 18.38 lakhs being the estimated liability under the
two gratuity schemes framed by the company, which was
deducted from the gross receipts in the P & L Account, it
being contended on behalf of the workmen that such deduction
was not justified while determining the ‘available surplus’
and the ‘allocable surplus’ for payment of bonus to them
under the Payment of Bonus Act, 1965. The Court rejected the
contention and adverting to the decision of House of Lords
in the case of Southern Rly. Of Peru Ltd. (supra) held that
an estimated liability under gratuity schemes even if it
amounted to a contingent liability and was not a ‘debt’
under the Wealth Tax Act, if properly ascertainable and its
present value was fairly discounted was deductible from the
gross-receipts while preparing the P & L Account. The
material portion of the head-note appearing at page 54 of
the report runs thus:
“Contingent liabilities discounted and valued as
necessary, can be taken into account as trading
expenses if they are sufficiently certain to be capable
of valuation and if profits cannot be properly
estimated without taking them into consideration. An
estimated liability under a scheme of gratuity if
properly ascertainable and its present value is
discounted, is deductible from the gross receipts while
pre paring the P & L account. This is recognised in
trade circles and there is nothing in the Bonus Act
which prohibits such a practice. Such a provision
provides for a known liability of which the amount can
be determined with substantial accuracy. It cannot,
therefore, be termed a “reserve”. Therefore, the
estimated liability for the year on account of a scheme
of gratuity should be allowed to be deducted from the
gross profits. The allowance is not restricted to the
actual payment of gratuity during the year.”
At page 62 of the Report this Court observed thus:
“Two questions, therefore, arise: (I) whether it
is legitimate in such a scheme of gratuity to estimate
the liability on an actuarial valuation and deduct such
estimated liability in the P & L Alc while working out
its net profits; (2) if it is, b whether such
appropriation amounts to a reserve or a provision?.. In
the case of an assessee maintaining his accounts on
mercantile system, a liability already accrued, though
to be discharged at a future date, would be a proper
deduction while working out the profits and gains of
his business, re-
811
gard being had to the accepted principle of commercial
A practice and accountancy . It is not as if such
deduction is permissible only in case of amounts
actually expended or paid. Just as receipts, though not
actual receipts but accrued due, are brought in for
income-tax assessment, so also liabilities accrued due
would be taken into account while working out the
profits and gains of the business”.
Again at page 64 of the Report this Court observed thus:
“In the instant case the question is not whether
such estimated liability arising under the gratuity
schemes amounts to a debt or not. The question that
concerns us is whether while working out the net
profits, a trader can pro vide from his gross receipts
his liability to pay a certain sum for every additional
year of service which he receives from his employees.
This, in our view, he can do if such liability is
properly ascertainable and it is possible to arrive at
a proper discounted present value. Even if the n
liability is a contingent liability, provided its
discounted present value is ascertainable, it can be
taken into account. Contingent liabilities discounted
and valued as necessary can be taken into account as
trading expenses if they are sufficiently certain to be
capable of valuation and if profits cannot be properly
estimated without taking them into account.”
In the case of Workmen of William Jacks . Co. Ltd. v.
Management of Jacks & Co. Ltd. Madras (1) another decision
under the Payments of Bonus Act, 1965, this Court, after
referring to the distinction pointed out in Metal Box Co’s
case between the two concepts ‘provision’ and ‘reserve’ has
observed on page 547 as follows:
“The provision for gratuity, furlough salary,
passage, service and commission, in the present case
was all made in respect of existing and known
liabilities though in some cases the amount could not
be ascertained with accuracy. It was not a case where
it was an anticipated loss or anticipated expenditure
which would arise in future. Such provision is
therefore not a reserve at all and cannot be added back
under item 2 (c) of the Second Schedule.”
812
In the above case also the Court was concerned with the
question whether particular provision made for gratuity,
furlough salary, passage, etc. was a reserve or a provision
for the purpose of Second Schedule to the Payment of Bonus
Act, 1965. At page 546 of the report the Court has
categorically observed that all these items, namely,
gratuity furlough salary, passage, service, commission, etc.
were clearly in respect of liabilities which had already
accrued in the years in which the provision was made and
were not in respect of anticipated liabilities which might
arise in future and, therefore, the Court held that the said
provision was not a reserve but a provision.
From the aforesaid discussion of the case law it seems
to us clear that the propositions indicated by us earlier
clearly emerge. Since in the instant case sufficient
material throwing light on the above aspects of the question
has not been made available, we think, it will be in the
interest of justice to remand the case through the Tribunal
to the taxing authority to decide the issue whether the con-
cerned amount (Rs. 9,O8,1061-) set apart and transferred to
gratuity reserve by the assessee company was either a
provision or a reserve and if the latter to what extent? The
taxing authority will decide the issue in light of the above
principles after giving an opportunity to the assessee
company to place additional relevant materials before
Turning to the last item of appropriation by way of
provision for proposed dividends, which arises in all these
matters (except in Tax Reference Case No. 511978 of Hyco
Products Pvt. Ltd.) the common question is whether the
concerned amount appropriated or set apart by the assessee-
companies from out of the profits and other surpluses by way
of making provision for ‘proposed dividends’ constituted a
provision or a reserve on the relevant date ?
It is true that under s. 27 of the Companies Act, 1956
the Directors 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 share-holders at the
annual general meeting of the company decide to accept the
recommendation and pass a resolution for declaration of the
dividend. It is therefore open to the directors to withdraw
or modify their recommendation at any time before the
shareholders accept the same and it is equally open to the
shareholders not to accept the recommendation at all or to
declare a dividend of an amount lesser than that recommended
by directors. In Kesoram
813
Industries case (supra) this Court has clarified the
aforesaid legal A position by observing at page 772 of the
report, thus:
“The directors cannot distribute dividends but
they can only recommend to the general body of the
company the quantum of dividend to be distributed.
Under section 217 of the Indian Companies Act, there
shall be attached to every balance-sheet laid before a
company in general meeting a report by its board of
directors with respect to, interalia, the amount, if
any, which it recommends to be paid by way of dividend.
Till the company in its general body meeting accepts
the recommendation and declares the dividend, the
report of the directors in that regard is only a
recommendation which may be withdrawn or modified as
the case may be. As on the valuation date (under the
Wealth Tax Act) nothing further happened than a mere
recommendation by the directors as to the amount that
might be distributed as dividend, it is not possible to
hold that there was any debt owed by the assessee to
the share holders on the valuation date.”
All that follows from above is that in the instant
cases the appropriations 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 automatically convert the appropriation
into ‘reserves’, regard being had to the negative and non-
exhaustive character of the definition of ‘reserve’ given in
cl. 7 (I)(b) of Part III of the Sixth Schedule to the
Companies A ct. The question whether the concerned amounts
in fact constituted ‘reserves’ or not will have to be
decided by having regard to the true nature and character of
the sums so appropriated depending on the surrounding
circumstances particularly the intention with which and the
purpose for which such appropriations had been made.
We have already indicated that according to the
dictionaries (both oxford and Webster) the applicable
meaning of the word ‘reserve’ is: “to keep for future use or
enjoyment; to set apart for some purpose or end in view; to
keep in store for future or special
814
use; to keep in reserve.” In other words, the word ‘reserve’
as a noun in ordinary parlance would mean “something which
is kept for future use or stored up for something or set
apart for some purpose”. It cannot be disputed that a
reserve may be a general reserve or specific reserve and all
that is required is that an amount should be kept apart for
some purpose, either general or specific. Eeven so the
question is whether the earmarking of a portion of pro fits
by the board of directors of a company avowedly for the
purpose of distributing dividend would fall within the
expression ‘reserve’ occurring in rule T of the Second
Schedule to the Super Profits Tax Act, 1963? For this
purpose certain tests indicated in some decisions of this
Court will have to be considered: The first decision of this
Court in that behalf is the decision in Century Spinning and
Manufacturing Company’s ease (supra). In that case the
material facts were these: For the year ending 31st
December, 1946, the profit of the assessee-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, 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 the
purposes of income tax. On 28th February, 1946, the Board of
directors recommended out of that amount the sum of Rs.
4,92,426 should be distributed as dividend and the balance
of Rs. 16,211 was to be carried forward to the next year’s
account. This recommendation was accepted by the share-
holders in their meeting on 3rd April, 1946, and the amount
was shortly afterwards distributed as dividend. In computing
the capital of the assessee company on 1st April, 1946,
under the Business Profits Tax Act, 1947, the assessee
claimed that the sum of Rs. 5,08,637 and the profit earned
by it during the period 1st January, 1946 to 1st April,
1946, should be treated as “reserves” for the purpose of
rule 2(1) of Schedule IT. The High Court held that the sum
of Rs. 5,08,637 must be treated as a reserve for the purpose
of rule 2, but the profit made by the assessees during the
period 1st January, 1946 to 1st April, 1946 could not be
included in the reserves. On appeal to this Court, it was
held that the sum of Rs. 5,08,637 as well as the profits
earned by the assessee during the period 1st January, 1946
to 1st April, 1946 did not constitute “reserves” within the
meaning of rule 2 (1) of Schedule II. After noting that the
expression ‘reserve’ had not been defined in the Business
Profits Tax Act, 1947 and after noting dictionary meanings
of that expression the Court observed:
815
” What is the true nature and character of the
disputed A sum must be determined with reference to the
substance of the matter and when this is borne in mind,
it follows that the 1st of April, 1946 which is the
crucial date, the sum of Rs. 5,08,637 could not be
called a reserve for nobody possessed of the requisite
authority had indicated on that date the manner of
disposal or distination. On the other hand, B on the
28th February, 1946 the directors clearly earmarked it
for distribution as dividend and did not make it a
reserve. Nor did the company in its meeting of 3rd
April, 1946 decide that it was a reserve. It remained
on the 1st of April, as a mass of undistributed profits
which were available for distribution and not earmarked
as “reserve”. On the 1st of January, 1946 the amount
was simply brought from the profit and loss account to
the next year and nobody with any authority on that
date made or declared a reserve. The reserve may be a
general reserve or a specific reserve, but there must
be a clear indication to show whether it was a reserve
either of the one or the other kind. The fact that it
constituted a mass of undistributed profits on the 1st
Jan. 1946 cannot automatically make it a reserve. On
the 1st April, 1946 which is the commencement of the
chargeable accounting year, there was merely a
recommendation by the directors that the amount in
question should be distributed as dividend. Far from
showing that the directors have made the amount in
question a reserve it shows that they had decided to
earmark it for distribution as dividend.”
The decision clearly lays down that the true nature and
character of the appropriation must be determined with
reference to the substance of the matter; obviously this
means that one must have regard to the intention with which
and the purpose for which appropriation has been made, such
intention and purpose being gathered from the surrounding
circumstances. In that behalf the following aspects
mentioned in the judgment provide some guidelines: (a) a
mass of undistributed profits cannot automatically 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 a general reserve or a
specific reserve, (b) the surrounding circumstances should
make it apparent that the amount so ear-marked 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
816
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 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 Second Schedule of the Business
Profits Tax Act, 1947.
Two more decisions of this Court one in First National
City Bank v. Commissioner of Income-Tax (1) and the other in
Commissioner of Income-Tax (Central), Calcutta v. Standard
Vacuum oil Co.(2) which provide two more guidelines, may now
be considered. In both these cases the Court was concerned
with the question whether the amount set apart as “undivided
profit” or set apart as “earned surplus” in accordance with
the system of accountancy which obtained in the United
States amounted to a reserve liable to be included in the
capital computation under rule 2 of Schedule II of the
Business Profits Tax Act, 1947. In both the cases the
assessees were non-resident companies and followed the
system of accounting that obtained in the American
commercial world. In the first case Justice Kapur, speaking
for the court, pointed out the difference between the two
system of accounting at Page 23 of the Report thus:
“In India at the end of an year of account the
unallocated profit or loss is carried forward to the
account of the next year, and such unallocated amount
gets merged in the account of that year. In the system
of accounting in the USA each year’s account is self-
contained and nothing is carried forward. If afteral
locating the profits to diverse heads mentioned above
any balance remains, it is credited to the “undivided
profits” which become part of the capital fund. If in
any year as a result of the allocation there is loss
the accumulated undivided profits of the previous years
are drawn upon and if that fund is exhausted the
banking company draws upon the surplus. In its very
nature the undivided profits are accumulation of
amounts of residue on hand at the end of the year of
successive periods of accounting and these amounts are
by the prevailing accounting practice and the Treasury
directions regarded as a part of the capital fund of
the banking company.’
817
After quoting with approval the above observations, Mr.
A Justice Shah in Standard Vacuum Oil Co.’s case went on to
observe at page 695 of the report as follows:
“It is true that the court in that case was
dealing with a case of a banking company but the
characteristics noted are not peculiar to the accounts
of a banking company; they are applicable with
appropriate variations to the accounts of all companies
in which different nomenclatures are used in the
accounts to designate the residue on hand as ‘surplus’,
‘ undivided profits’ or ‘earned surplus’.
Where the balance of net profits after allocation
to specific reserves and payment of dividend are
entered in the account under the caption ‘earned
surplus’, it is intended thereby to designate the fund
which is to be utilised for the purpose of the business
of the assessee. Such a fund may be regarded according
to the Indian practice as ‘general reserve”)
This Court in the first case held that the amount designated
as “undivided profits” which was available for continuous
future use of the business for the bank was a part of the
reserve and had to be taken into account while computing the
capital under rule 2(1) of Schedule II of the Business
Profits Tax Act; similarly, in the second case the Court
held that the amount which had been allocated to “earned
surplus” which was intended for the purpose of the business
of the assessee company and was used in subsequent years in
business, represented ”reserves” within the meaning of rule
2 of Schedule II of the Business Profits: Tax. From these
two decisions two aspects emerge very clearly. In the first
place, the nomenclature accorded to any particular fund
which is set apart from out of the profits would not be
material or decisive of the matter and secondly, having
regard to the purpose of rule of 2 of Schedule II of the
Business Profits Tax Act, 1947, if any amount set apart from
out of the profits is going to make up capital fund of the
assessee and would be available to the assessee for its
business purposes, it would become a reserve liable to be
included in the capital computation of the assessee under
that Act.
The provisions of the Companies Act 1956 also lend
support to the proposition that an appropriation for
proposed dividend would not amount to a reserve. Section
217(1) runs thus:
818
“217(1) There shall be attached to every balance
sheet laid before a company in general meeting, a
report by its Board of directors, with respect to-
(a) the state of the company’s affairs,
(b) the amounts, if any which it proposes to
carry to any reserves in such balance sheet,
(c) the amounts, if any, which it recommends
should be paid by way of dividend;
(d) …………………………… ”
Regulation 87 of Table A in the First Schedule runs thus:
“87(1) The Board may, before recommending any
dividend, set aside out of the profits of the company
such sums as it thinks proper as a reserve or reserves
which shall, at the discretion of the Board, be
applicable for any purpose to which the profits of the
company may be properly applied, including provision
for meeting contingencies or for equalising dividends;
and pending such application may at the like
discretion, either be employed in the business of the
company or be invested in such investments (other than
shares of the company) as the Board may, from time to
time, think fit.
(2) The Board may also carry forward any profits
which it may think prudent not to divide, without
setting them aside as a reserve.”
The aforesaid provisions read together clearly show that
creating re serves out of the profits is a stage distinct in
point of fact and anterior in point of time to the stage of
making recommendation for payment of dividend and the scheme
of the provisions suggests that appropriation made by the
Board of Directors by way of recommending a payment of
dividend cannot in the nature of things be a reserve.
If regard be had to the guide-lines indicated above as
well as the provisions of the Companies Act 1956 specified
above we are clearly of the opinion that the appropiations
made by the directors for proposed dividend in the case of
the concerned assessee-companies do not constitute
‘reserves’ and the concerned amounts so set apart would have
to be ignored or excluded from capital computation.
819
Since we have reached the aforesaid conclusion on first
principles and on the basis of the guidelines discussed
above it is unnecessary for us to go into or discuss the
scope and effect of the Explanation to Rule 1 in Second
Schedule to The Companies (Profits) Sur-tax Act, 1964 though
it seems to us prime facie that the Explanation, being
clarifacatory in nature is declaratory of the existing legal
position.
Dealing with the last case of Hyco Products Pvt. Ltd.
Bombay (Tax Reference Case No. 5 of 1978), where the
question pertaining to dividend but in a different form
arises for consideration, the admitted facts may briefly be
stated. The question relates to the Assessment Year 1974-75,
the relevant previous year being calendar year 1973 and the
material date being 1.1.1973. After the accounts of the
calendar year 1972 were finalised the directors transferred
out of the profits of Rs. 61,03,382 of that year a sum of
Rs. 29,77,000 to the General Reserve. With such tranfer the
General Reserve of the assessee company as on 1.1.1973 stood
at Rs. 86,07,712. At the end of the calendar year, 1973
admittedly the directors did not make any provision for
‘proposed dividend’ in its accounts but there was note on
the Balance Sheets to the following effect:-
“The directors have recommended dividend for the
year 1972 at the rate of Rs. 10/- per share free of
tax. The dividend, if approved by the share-holders at
the forth- coming Annual General Meeting, will be paid
out of General Reserve and no separate provision has
been made therefor in the accounts.”
At the Annual General Meeting held on June 30, 1973 dividend
of Rs. 3,10,450 was declared by the share-holders and the
same was soon thereafter paid out of the said General
Reserve. In the surtax assessment proceedings under the 1964
Act the assessee claimed that the entire general reserve
which stood as Rs. 86,07,712 as on 1.1.1973 should be taken
into account while computing the capital of the assessee
company. But the taxing officer reduced the general reserves
by the aforesaid sum of Rs. 3,10,450 and only the balance of
Rs. 82,97,262 was added in computing the capital. The
Appellate Assistant Commissioner as well as the Income-Tax
Appellate Tribunal, Bombay confirmed the order of the Taxing
officer. The Tribunal took the view that though it was not a
case of ‘pro- posed dividend’ since the amount actually paid
out as dividend was a smaller sum than the amount
transferred from out of profits to
820
the General Reserve that amount could not form part of the
reserve and therefore the General Reserve as reduced by Rs.
3,10,450 was properly taken into account for the purpose of
computation of the capital as on the relevant date. At the
instance of the assessee the Tribunal has referred the
following question of law directly to this Court for its
opinion under s. 257 of the Income Tax Act 1961 read with s.
18 of the Companies (Profits) Sur-tax Act, 1964:
“Whether on the facts and in the circumstances of
the case the Tribunal was justified in excluding a sum
of Rs. 3,10,450 representing the dividends declared for
the calendar year 1972 from the General Reserves on the
opening date of the previous year while computing the
capital under the Second Schedule of the Companies
(Profits) Sur-tax Act, 1964 for the assessment year
1974-75?”
Counsel for the assessee-company contended that after
con ceding that this was not a case of “proposed dividend”
the Tribunal erred in holding that the sum of Rs 3,10,450
representing the dividends paid out from the General Reserve
was liable to be excluded while computing the capital of the
company as on 1.1.1973 for purposes of sur-tax assessment
under the 1964 Act. According to him under s. 205(1) of the
Companies Act, 1956 dividend can be paid from out of the
current year’s profits or profits of any previous financial
year or years and there is no presumption in law or in
commercial accounting that a dividend has to be paid either
from the current year’s profits or from the past year’ s
profits. He further urged that once from out of the current
year’s profit a certain sum is transferred to the General
Reserve it merges into the latter and the General Reserve so
augmented becomes a conglomerate fund and if out of such
conglomerate fund any sum is recommended or paid out as
dividend it will be difficult to say that such payment has
come out of the portion of current year’s profits that has
been transferred and merged and there is no reason why the
principle ‘Last-in, First-out’ should be invoked for drawing
the inference that the payment has been made out of the
current year’s profits. He pointed out that such a principle
was applied by the Bombay High Court in two decisions,
namely, Commissioner of Income-Tax, Bombay City-l v. Bharat
Bijlee Ltd.(1) and Commissioner of Income Tax, Bombay City-
ll v. Marrior (India) Ltd.(2) but urged that there
821
was no warrant for it. In support of his contention that the
entire A General Reserve of Rs. 86,07,712 without any
deduction should have been taken into account while
computing the capital of the assessee-company, counsel
relied upon a decision of the Andhra Pradesh High Court in
Super Spinning Mills Ltd. v. Commissioner of Income Tax,
Hyderabad(l).
Alternatively counsel pointed out that as far as stock
valuation is concerned a question often arises whether the
stock on hand at the end of the year is to be valued at the
closing price or at the initial purchase price and in
‘Advanced Accounting’ by R. Keith Yorston and E. Bryan Smyth
(a treatise on the principles and practice of accounting in
Australia) three methods of valuing the closing stock have
been indicated at pages 441 and 442 of Vol. II (5th Edn.) of
the treatise, namely, (a) First-in First-out, (b) Last-in
First-out and (c) Average Cost. In regard to these three
methods the authors have stated thus .
(a) First-in First-out
The assumption underlying this method is that the
oldest stock is used or issued first or that sales are
made in the order in which the goods are purchased or
produced. If there are several lots of goods at
different prices, they are regarded as being exhausted
in the order of purchase. On a rising market this would
write off the lower-priced lots first, and on a falling
market the higher-priced lots would go first.”
(b) “Last-in First-out.
This method assumes that the items of stock
purchased are the first to be issued or sold and thus
the stock remaining is valued at the cost of the
earlier purchase.”
(c) Average Cost.
On this basis issues of stocks are valued at the
weighted average cost of the stock on hand at the
beginning and of the purchases, less any issues already
made.”
822
Counsel for the assessee urged that for determining whether
the entire General Reserve of Rs. 86,07,712 or reduced
General Reserve of Rs. 82,97,262 should be taken into
account for capital computation either the ‘First-in First-
out’ principle should be adopted; if not, only a
proportionate deduction should be made and the balance
should be held to be includible in capital computation,
particularly because the payment of dividend has been from a
conglomerate fund.
It is not possible to accept either of these
contentions urged by counsel for the assessee-company. It is
true that under s. 205(1) a of the Companies Act, 1956 it is
open to the directors to recommend and the share-holders to
approve payment of dividends either from the current year’s
profits or from the past year’s profits. It is also true
that on transfer of a portion of current year’s profits to
the General Reserve the augmented General Reserve becomes a
conglomerate fund but having regard to the natural course of
human conduct of hard-headed men of business and commerce it
is not difficult to predicate that the dividends would
ordinarily be paid out from the current income rather than
from the past savings unless the directors in their report
expressly or specifically state that payment of dividends
would be made from the past savings. From the commercial
point of view if any amount is required for incurring any
expenditure or making any disbursement like distribution of
dividends in a current year, then ordinarily the same will
come out of the current income of the company if it is
available and only if the same is insufficient then the past
savings will be resorted to for the purpose of incurring
that expenditure or making that disbursement; such a course
would be in accord with the common sense point of view. We
may point out that this aspect of the matter was not
considered by the Andhra Pradesh High Court in Super
Spinning Mills Ltd. case (supra) and the view of the Bombay
High Court in the case of Bharat Bijlee Ltd. (supra) and
Marrior (India) Ltd. (supra) commends itself to us. Even in
regard to the question of valuing the closing stock the
learned authors of the treatise referred to by the counsel
for the assessee-company merely indicate three methods for
such valuation and it will be open to a commercial concern
to avail of any one method. In our view in the context of
the question whether while incurring any expenditure or
making any disbursement a commercial concern will resort to
current income or past savings, the normal rule, in the
absence of express indication to the contrary, would be to
resort to the current income rather than past savings.
823
In our view, therefore, the Tribunal was right in
excluding the sum of Rs. 3,10,450 from the General Reserves
while computing the capital of the assessee-company for the
assessment year ]974-75, in the absence of express
indication to the contrary.
In the result Civil Appeal No. 1614(NT) of 1978 and
Review Petition No. 57 of 1980 are dismissed. Civil Appeal
No. 860 of g 1973 is partly allowed and the issue whether
the appropriation for retirement gratuity is a reserve or
not is remanded to the Taxing Authority and the rest of the
appeal is dismissed. In Tax Reference Cases Nos. 2 and 3 of
1977 and No. S of 1978 the questions referred to us are
answered in favour of the Department and against the
assessee-companies. Each party will bear its own costs in
all the matters.
AMARENDRA NATH SEN, J. At the outset I wish to observe
that I have been somewhat diffident in hearing these
matters. I felt a little embarrassed as I found that as a
Judge of the High Court at Calcutta, I had an occasion to
consider some of the questions in the case of Braithwaite
and Co. (India) Ltd. v. Commissioner of. Income- Tax, West
Bengal, (I) (Income Tax Reference No. 262 of 1969). As I
have already considered some of the questions and have
expressed my views on the same in the judgment delivered by
me in the said reference, I was wondering whether I should
hear these appeals. The members of the Bar, however,
represented to me that they had not only no objection to my
hearing these appeals but they also wanted me to hear these
appeals. They further represented that most of the Judges of
this Court had on some occasion or other considered these
questions. They further stated that if I would decline to
take up these matters not only the members of the Bar who
had come from various parts of the country for these appeals
would be seriously inconvenienced; but also the litigant
public who had been waiting for years for the hearing of
these matters would be prejudiced. It was further pointed
out to me that the judgment which was delivered by me was
not under appeal and further it would appear from the
judgment which I had earlier delivered in Braithwaite
matter, there was in fact a concession made by the learned
counsel appearing on behalf of the assessee that the said
case was covered by the decision of the Supreme Court in the
case of Commissioner of Income-tax Bombay City v. Century
Spinning and Manufacturing Co. Ltd. (‘) The learned counsel
appearing on behalf
824
of the parties further represented to me that the earlier
judgment was delivered by me as a Judge of the High Court
and it was always open to me to reconsider ‘ my view,
particularly as a Judge of this Court after hearing the
submissions to be made by the learned counsel appearing on
behalf of the parties. In view of the aforesaid
representations and submissions made by the learned lawyers,
I was persuaded to hear these appeals with my learned
brothers to avoid inconvenience not only to the lawyers but
to the litigant public. I have also had no doubt in my mind
that if I felt after hearing the submissions made by the
learned counsel appearing on behalf of the parties in these
appeals, that the earlier judgment delivered by me was wrong
and incorrect, I would have no hesitation in reconsidering
my earlier decision.
I do not propose to set out the facts of this case at
any length in this judgment. The facts have been fully and
correctly set out in the judgment of my learned brother
Tulzapurkar, J. My learned brother in his judgment has also
dealt with the various arguments which were advanced from
the Bar and has also considered the decisions which were
cited.
I propose to notice only some of the decisions which,
to my mind, are particularly important for decision of the
question whether the provision made in the balance-sheet for
payment of dividend to the share-holders recommended by the
Board of Directors constituted a ‘reserve’ and the amount,
so set apart, should be taken into account, in computing the
capital of the company for the purpose of Super-Profits Tax
Act, 1963. It may be noted that in the Act itself the
expression ‘reserve’ has not been defined.
In the case of Commissioner of Income-tax, Bombay City
v. Century Spinning and Manufacturing Co. Ltd. (supra), this
Court had the occasion to consider the meaning of the word
‘reserve’ while dealing with a case under Business Profits
Tax Act (XXI of 1947). In this Act also, there were similar
provisions with regard to computation of the capital of the
Company and the assessee had claimed that the amount
recommended by the Board of Directors and earmarked for
payment of the dividend to the share-holders should be
treated as ‘reserve’ and should be taken into consideration
in computing the capital of the assessee. The Supreme Court
observed at pp. 503-504 as follows :-
“The term ‘reserve’ is not defined in the Act and
we must resort to the ordinary natural meaning as
understood
825
in common parlance. The dictionary meaning of the word
‘reserve’ is :-
“1 (a) To keep for future use or enjoyment;
to store up for some time or occasion; to refrain
from using or for enjoying at once.
(b) To keep back or hold over to a later time
or place or for further treatment.
6. To set apart for some purpose or with some
end in view; to keep for some use.
II. To retain or preserve for certain
purposes (oxford Dictionary, Vol . VIII, P. 513.)
In Webster’s New International Dictionary
Second Edition, page 2118 ‘reserve’ is defined as
follows:
1. To keep in store for future or special
use; to keep in reserve; to retain, to keep, as
for oneself.
2. To keep back; to retain or hold over to a
future time or place.
3. To preserve.”
The Supreme Court further observed at p. 504: “What is
the true nature and character of the disputed sum, must be
determined, with reference to the substance of the matter?”
The Supreme Court held at p. 504-505 as follows :-
“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 dividend to the shareholders but kept
back by the directors for any purpose to which it may
be put in future. Therefore, giving to the ‘reserve’
its plain natural meaning it is clear that the sum of
Rs. 5,08,637 was kept in reserve by the company and
not distributed as profits and subjected to taxation.
Therefore, it satisfied all the requirements of rule 2.
The Directors had no power to distribute the sum as
dividend. They could only recommend as indeed they did,
and it was upto the shareholders of the company to
accept that recommendation in which case alone the
826
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
crucial date did not constitute reserves within the
meaning of Schedule II, rule 2(1).”
The Supreme Court also referred to S.l31 (a) and 132 of
the Indian Companies Act. Referring to these sections the
Supreme Court observed at p. 505 as follows:
“Section 131 (a) enjoins upon the directors to
attach to every balance sheet a report with respect to
the state of company’s affairs and the amount if any
which they recommend to be paid by way of dividend and
the amount, if any, which they propose to carry to the
reserve fund, general reserve or reserve account. The
latter section refers to the contents of the balance
sheet which is to be drawn up in the Form marked in
Schedule III. This Form contains a separate head of
reserves. Regulation 99 of the Ist Schedule. Table A,
lays down ‘that the directors may, before recommending
any dividend set aside out of the profits of the
company such sums as they think proper as a reserve or
reserves which shall, at the discretion of the
directors, be applicable for meeting contingencies, or
for equalising dividends, or for any other purpose to
which the profits of the company may be properly
applied.. ‘ The Regulation suggests that any sum out of
the profits of the company which is to be made asa
reserve or reserves must be set aside before the
directors recommend any dividend. In this case the
directors while recommending dividend took no action to
set 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.”
In the case of Commissioner of Income Tax v. Standard
Vacuum oil Co. (1) this Court had occasion to consider the
decision in
827
the case of Commissioner of Income-tax v. Century Spinning
and A Manufacturing Co. Ltd. (supra). Dealing with the said
decision of this Court held at p. 697-98 as follows :-
“The Court was dealing in this 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. rt is on
these facts that the court held that there was no
allocation of the amount to reserve and from the mere
fact that it was carried forward in the account of the
next year and ultimately applied in payment of
dividend, it could not be said to be specifically set
apart for any purpose at the relevant date, i. e. the
end of the year of account.”
This Court then proceeded to hold at p. 697-98 as
follows :-
“We are in this case dealing with a foreign
company and the system of accounting followed by the
company is different in important respects from the
system which obtains in India. Companies in India
maintain diverse types of reserves: such as capital
reserve, reserve for redemption of debentures, reserve
for replacement of plant and machinery, reserve for
buying new plant to be added to the existing ones,
reserve for bad and doubtful debts? reserve for payment
of dividend and general reserve. Depreciation reserves
within the limit prescribed by the Income-tax Act or
the Rules thereunder is the only reserve which is a
permissible allowance in the computation of taxable
profits. In its ordinary meaning the expression
‘reserve’ means something specifically kept apart for
future use or for a specific occasion.”
In the case of Metal Box Company of India Ltd. v. Their
Workmen, (1) this Court while dealing with a case under the
pay-
828
ment of Bonus Act, 1965 had occasion to consider the
expression ‘reserve’ and its meaning for the purpose of the
said Act. This Court held at p. 67-68 as follows :-
” The next question is whether the amount so
provided is a provision or a reserve. This 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 asset by which they are
represented being retained in 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 (see Spicer and Pegler’s
Book-keeping and Accounts, 15th Edn. page 42). An
amount set aside out of profits and other surpluses,
not designed to meet a liability, contingency,
commitment or diminution in value of assets known to
exist at the date of the balance-sheet is a reserve but
an amount set aside out of profits and other surpluses
to provide for any known liability of which the amount
cannot be determined with substantial accuracy is a
provision; (see William Pickles Accountancy, Second
Edn. p. 192; Part III, clause 7, Schedule VI to the
Companies Act, 1958, which derives provision and
reserve.”
In the case of Commissioner of Income-tax v. Mysore
Electrical Industries Ltd.(1) the facts were briefly as
follows:-
Out of the profits of the company for the accounting
period ending March 31, 1963. the Directors of the company
appropriated the following amounts towards reserves on
August 8, 1963: (i) Rs. 2,56,000 as plant modernisation and
rehabilitation reserve: (ii) Rs. 89,557 as development
rebate reserve. The question was whether these amounts could
be included in computing the capital of the respondent as on
April 1, 1963 under rule 1 of Schedule II to the Companies
(Profits) Sur-tax Act, 1964. for the purpose of the
statutory deduction for the assessment year 1961-65, The
contention of the department was that since the
appropriations were made on 8th August, 1963 they could not
be treated as components of capital as on the first day of
the previous year i.e. 1st April, 1963. Negativ-
829
ing the contention of the department, this Court held that
the determination of the Directors to appropriate the
amounts of the three items of reserve on 8th August, 1963
had to be related to first April, 1963, viz., the beginning
of the accounts for the new year, and had to be treated as
effective from that day and the said three items had to be
added to the other items for computation of the capital of
the company as on first April, 1963 under rule 1 of Schedule
II to the Companies (Profits) Sur-tax Act, 1964. It may be
noted that in this case before the trial court a claim had
been made by the company that a sum of Rs. 3,15,000
representing dividend reserve was to be considered in
computing the assessee’s capital for the purpose of
Companies (Profits) Sur-tax Act, 1964 and the High Court had
rejected this claim. As against the rejection of this claim
by the High Court, no appeal had been preferred by the
assessee to the Supreme Court. The Supreme Court while
considering the three items which came up for consideration
before it held, as already noted, that the decision of the
directors to appropriate the amounts to these three items of
reserve on 8th August, 1963 had to be related to 1st April,
1963 and this Court observed at pp. 560-570 as follows:-
“It is well known that the accounts of the company
have to be made up for a year up to a particular day.
In this case that day was the 31st March, 1963. If it
was reasonably practicable to make up the accounts up
to the 31st March, 1963, and present the same to the
directors of the respondent on April 1, 1963, they
could have made up their minds on that day and declared
their intention of appropriating the said and other
sums to reserves of different kinds. But the fact that
they could not do so for the simple reason that the
calculation and collection of figures of all the items
of income and expenditure of the company for the year
ending March 31, 1962, was bound to take some time
cannot make any difference to the nature or quality of
the appropriation of the profits to reserves as
determined by the directors after the first of April,
1963. Their determination to appropriate the sums
mentioned to the three separate classes of reserves on
the 8th August, 1963, must be related to the 1st of
April, 1963, i.e., the beginning of the accounts for
the new year and must be treated as effective from that
day”.
830
Relying on the aforesaid decisions and also many other
decisions of the various High Courts which have been
considered by my learned brother Tulzapurkar, J. in his
judgment, the learned counsel for the assessee has argued
that the word ‘reserve’ which has not been defined in the
Act, has to be understood in its ordinary meaning as laid
down by the Supreme Court in the case of Century Spinning
Mills Ltd. The further argument is that the recommendation
for dividend by the directors of the Company does not create
any kind of liability, immediate or future. It is argued
that the obligation to pay the dividend only arises when the
shareholders at the Annual General Meeting of the Company
decided to accept the recommendation of the Directors and
pass a resolution for declaration of dividend. It is
submitted that it is open to the Directors to withdraw or
modify the recommendations made by them any time before the
shareholders accept the recommendations and in support of
this contention reference is made to the decision of this
Court in the case of Keshoram Industries and Cotton Mills
Ltd. v. Commissioner of Wealth Tax (Central), Calcutta (I)
and n reliance is placed on the following observations at p.
772 :-
“The directors cannot distribute dividends but
they can only recommend to the general body of the
company the quantum of dividend to be distributed.
Under section 217 of the Indian Companies Act, there
shall be attached to every balance-sheet laid before a
company in general meeting a report by its board of
directors with respect to, inter alia, the amount. if
any, which it recommends to be paid by way of dividend.
Till the company in its general body meeting accepts
the recommendations and declares the dividend, the
report of the directors in that regard is only a
recommendation which may be withdrawn or modified as
the case may be. As on the valuation date nothing
further happened than a mere recommendation by the
directors as to the amount that might be distributed as
dividend, it is not possible to hold that there was any
debt owed by the assessee to the share holders on the
valuation date.”
It is further argued that it is open to the share-holders to
accept the i recommendations in its entirety or to modify
the same by
831
deciding to declare dividend at a rate lower than the one
recommended by the directors. It is, therefore, contended
that the recommendation of the directors for payment of
dividend does not have the effect of creating any kind of
liability and there is no debt owed by the company by virtue
of the said recommendations. It has been submitted that the
decision of this Court in the case of Mysore Electrical
Industries Ltd. (supra) is of no assistance and the said
decision does not lay down that in the event of the share
holders’ acceptance of recommendation made by the directors
for the distribution of dividend to the share-holders of the
company, the liability for payment of the dividend will also
relate back; and the doctrine of relation-back applies only
in respect of items which the directors are competent to
decide for themselves, in view of the process involved in
the preparation of accounts of the company.
The main argument advanced on behalf of the Revenue is
that any amount which may be set apart for payment of
dividend r recommended to be paid by the Directors cannot
constitute ‘reserve’ within the meaning of the Act.
The argument advanced on behalf of the assessee appears
to be sound; but to my mind the said arguments are not
sufficiently convincing to lead the Court to the conclusion
that the amount set apart for payment of dividend
recommended by the Board of Directors can constitute
‘reserve’ within the meaning of the Act for the purpose of
computation of the capital of the Company.
The word ‘reserve’ has not been defined in the ACT. In
the absence of any such definition the word has to be
understood in its ordinary sense. It is, however, to be
remembered that the word ‘reserve’ in the instant case
occurs in a taxing statute specially applicable to Companies
only. The word ‘reserve’ should be so construed as to give
the said word the meaning in which it is ordinarily
understood by persons interested in Companies or in dealing
with Companies. In other words, the word ‘reserve’ for the
purpose of this Act should be understood in the sense in
which it is understood in company circles and by persons
interested in Companies and in dealing with Companies. It
may be noticed that while considering the true meaning and
true nature of ‘reserve’, the Supreme Court in the case of
Commissioner of Income Tax v. Century Spinning and
Manufacturing Co. Ltd. (supra) has referred
832
to S. 131 (a) and 132 of the Indian Companies Act, to the
Form marked in Schedule III in which balance sheet of the
Company has to be prepared and also to Regulation 99 of the
First Schedule, Table A. I have earlier quoted the relevant
observations of the Supreme Court.
It is, no doubt, true that the re commendations of the
Directors for payment of any dividend does not create any
kind of liability for the payment of the said amount. The
liability for payment of any amount by way of dividend only
arises when the share-holders accept the recommendations and
a dividend is declared at the annual general meeting of the
Company. It is open to the Directors to modify or withdraw
the recommendation with regard to the payment of dividend
before the said recommendation is accepted by the share-
holders. It is also open to the share-holders not to accept
the recommendation of the Directors in its entirety and to
modify the same. The legal liability for the payment of any
dividend only arises after the share-holders at the annual
general meeting have decided to declare a dividend on the
basis of the recommendations of the Directors or on the
basis of any modification thereof. The liability for the
payment of dividend only arises after the dividend has been
declared by the share-holders at the annual general meeting
and this liability does not relate back to 3 any earlier
date on the basis of the recommendations of the directors.
as the directors do not enjoy any power of declaring the b
dividend. The amount that may be set apart for payment of
any dividend on the basis of the recommendations made by the
Directors, cannot be considered to be an amount set apart
for meeting a known or existing liability.
Though the amount which is set apart for payment of any
dividend recommended by the Board of Directors is not an
amount set apart for meeting any known or existing
liability, yet the said amount so set apart cannot be
considered to be a ‘reserve’ within the meaning of the Act
for the purpose of computation of the capital of the
Company.
S. 210 of the Companies Act, 1956 specifically provides
that at every annual general meeting of a Company the Board
of Directors of a Company shall lay before the Company the
balance sheet of the Company and also the Profits and Loss
account. S. 211
833
further provides that every balance sheet of a Company shall
give a A true and fair view of the state of affairs of the
Company as at the end of the Financial Year and shall,
subject to the provisions of the section, be in the form set
out in Part I of Schedule VI, or as near thereto as
circumstances admit or in such other form as may be approved
by the Central Government either generally or in a parti-
cular case. The preparation of a balance sheet in the
prescribed form and laying the same before the share-holders
at the annual meeting are statutory requirements which the
Company has to observe.
Regulation 87 of Table A in Schedule I provides:
“(1) The Board may, before recommending any
dividend, set aside out of the profits of the Company
such sums as it thinks proper as a reserve or reserves
which shall, at the discretion of the Board, be
applicable for any purpose to which the profits of the
Company may be properly applied, including provisions
for meeting contingencies or for equalising dividends;
and pending such application, may at the like
discretion, either be employed in the business of the
company or be invested in such investments (other than
shares of the Company) as the Board may from time to
time, think fit.
(2) The Board may also carry forward any profits
which it may think prudent not to divide. without
setting them aside as a reserve”.
This Regulation contemplates that the Board may set aside
out of the profits of the Company such sums, as it thinks
proper, as a reserve or reserves which shall, at the
discretion of the Board, be applicable for any purpose to
which the profits of the Company may be properly applied
including the provisions for meeting contingencies or for
equalising the dividends, before recommending any dividend.
In other words, the sums out of the profits of the Company
have to be set apart as reserve before any dividend is
recommended by the Board; and the recommendation of the
Board for payment of dividend comes only after the creation
of reserve. The amount that may, therefore, be set apart for
payment of dividend recommended by the Board is an amount
which is set apart
834
after the Board had created the reserve. The form of balance
sheet referred to in S. 211 of the Companies Act, 1956 is
appended in Part I of Schedule VI of the Statute. In the
statutory form there are various heads including heads of
various kinds of reserves and also of provisions. In the
balance sheet of the Company which has necessarily been
prepared in accordance with the provisions of the statute
and in the form prescribed, the amount recommended by the
Board for payment of dividend has been shown under the head
provisions and not under any head of reserves. It is, no
doubt, true that the true nature and character of the sum so
set apart must be determined with regard lo the substance of
the matter. The substance of the matter clearly appears to
be that the amount is set apart for payment of dividend
recommended by the Board to be paid to the share-holders and
the said amount is never intended to constitute a reserve of
the Company. Indeed a provision is made for payment of the
said amount to the share-holders by way of dividend on the
basis of the recommendation made by the Directors. Though in
law the recommendation made by the Directors for payment of
dividend to share-holders does not create any liability for
the payment of dividend and liability only arises when the
shareholders accept the said recommendation, and though in
law it may be open to the Board to modify or withdraw the
recommendation with regard to the payment of dividend before
the acceptance by the share-holders and it may also be open
to the share-holders not to accept the said recommendation
in its entirety and to modify the same, yet, for business
purposes, when the directors make any recommendation for
payment of dividend and set apart any amount for the payment
of dividend so recommended, the directors intended to make a
provision for the payment of dividend recommended by them
and not to create any reserve, as the Directors very well
know that the recommendation made by them with regard to the
payment of dividend is not normally up-set by the share-
holders and it is generally accepted by the share-holders,
as a matter of course. Any amount set apart by the Directors
for payment of dividend to the share-holders recommended by
them, is understood by persons interested in company and in
dealing with companies to mean a provision for the payment
of dividend to the share-holders and is not understood to
constitute a reserve. In my opinion, this true nature and
character of the sum so set apart are reflected in the
provisions of the Companies Act and more particularly in the
manner of preparation of the balance-sheet of the Company. I
am, therefore, of the opinion that the amount set apart for
the payment
835
of any proposed dividend on the basis of the recommendation
of A the Directors cannot constitute reserve for the purpose
of computation of the capital of the Company. The view that
I have taken, to my mind, appears to be in accord with the
view earlier expressed by this Court in the decisions to
which I have already referred.
On the other questions, I entirely agree with the view
expressed by my learned brother Tulzapurkar, J. and I agree
with the order proposed by him.
C.A. No. 1614(NT)/78, Review Petition
No. 57180 and Tax Reference Cases
Nos 2&3/77 and 5/1978 dismissed.
P.B.R. C.A. No. 860/73 partly allowed.
836