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PETITIONER: COMMISSIONER OF INCOME TAX, KANPUR

       Vs.

RESPONDENT: THE ELGIN MILLS LTD., KANPUR

DATE OF JUDGMENT31/07/1986

BENCH: MUKHARJI, SABYASACHI (J) BENCH: MUKHARJI, SABYASACHI (J) PATHAK, R.S.

CITATION:  1986 AIR 1943            1986 SCR  (3) 398  1986 SCC  (3) 663        JT 1986     7  1986 SCALE  (2)112

ACT:      Companies (Profits)  Surtax Act,  1964, Schedule 2 Rule I-"Investment reserve",  "rehabilitation reserve",  "capital reserve", "depreciation  reserve" and "forfeited dividends"- Whether  statutory   deductions-"provision"  and  "reserve"- Distinction between.

HEADNOTE:      In Civil  Appeal No.  1665 of  1974,  a  dispute  arose between the  respondent-assessee and the Revenue with regard to  the  computation  of  "standard  deductions"  under  the provision of  Companies  Profits  (Surtax)  Act,  1964.  The respondent-assessee  claimed   that  the  three  amounts  in respect of  three accounts,  namely, (a)  investment reserve (b)  rehabilitation   reserve  and  (c)  forfeited  dividend reserve should  be treated  as reserves  for the purposes of computation of  its capital  for the assessment year 1964-65 of which  the relevant  previous year  ended on  30th Sept., 1963. The Income-tax officer did not include any of the said "reserves" in  the capital  of the respondent company on the basis that  these did  not represent  "reserve" in  the real sense. The  matter, ultimately  went before the Tribunal. It held: (i) that all the three accounts represented "reserves" for the  purposes of  assessment under the Super Profits Tax Act, 1963  and as  the principle  involved was  the same  as under the Companies Profits (Surtax) Act, 1964, the accounts in question  represented "reserves"  under  the  latter  Act also. The  High Court  also, relying on its earlier decision in Commissioner  of  Income-tax,  Kanpur  v.  British  India Corporation (P)  Ltd. 92 TIRE 38, affirmed the view taken by the Tribunal  and held (i) that under both the Acts charging sections  (s.   4)  were   identically  worded  except  that expression(Standard Deduction)  in Super  Profits  Tax  Act, 1963  had   been  replaced   by  the  expression  "statutory deductions" in  Companies Profits  (Surtax) Act,  1964; (ii) that under  both Acts  these deductions  had to  be computed with reference  to the  capital employed  in the assessee’s- Companies; and  (iii) that  under both  the Acts reserves of the company  were to  be treated as its capital and the only difference was in the 409

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Second Schedule  to the Companies Profits (Surtax) Act, 1964 where an  A explanation had been added, and this explanation merely clarified  what was  implicit in the Super Profit Tax Act, 1963.      In C.A.  No. 145  of 1976  the assessee-respondent  had shown capital  of Rs.2,63,79,218  which included  inter-alia investment reserve, rehabilitation reserve, capital reserve, depreciation reserve and forfeited dividends. The High Court held that  the first four items constituted reserves and the forfeited dividends account did not represent reserve.      Dismissing the C.A. No. 145 of 1976 and allowing CA No. 1665 of 1974 in part, ^      HELD: 1.1  The conclusion  of the High Court in CA 1665 of  1974   holding   that   the   investment   reserve   and rehabilitation reserve were reserves and were entitled to be treated so  under the  relevant Act  is right.  But, in  the facts of  the case,  the High Court was not right in holding that the  "forfeited dividend reserve" was reserve. However, in CA  No. 145  of 1976, the Tribunal and the High Court had rightly  excluded  "forfeited  dividend  account"  from  the reserve. [417G-H; 418D]      2.1 The  Supreme Court in Vazir Sultan Tobacco Co. Ltd. v. Commissioner of Income Tax [1981] 132 TIRE, 559 held that the expression  "reserve" in Super Profits Tax Act, 1963 and the  Companies  Profits  (Surtax)  Act,  1964  are  in  pari materia. [413C-D]      2.2 The  distinction between  "provision" and "reserve" is while  the "provision"  is a  charge of profits which are taken into  account in the gross receipt of Profits and Loss Account, "reserve"  is an appropriation of profit to provide for the asset which it represented. Reserve might be general or specific  reserve, what  is required  is that  the amount should be  kept apart  for one  or the  other purpose either general or  specific. The  distinction between provision and reserve must  be found out bearing in mind the main features of the  reserve. These  are: (i) it must be an appropriation of profits,  current or accumulated and not a charge against the profits  for the  year; (ii)  the conduct of the parties must bear  out that  intention; (iii)  it must not be to set apart to meet any known liability-a liability known to exist on the date of the balancesheet. [416A-C]      In the  instant cases,  keeping in  view the  aforesaid tests, invest- 410 ment reserve,  rehabilitation reserve,  capital reserve  and depreciation reserve constituted "reserves" and are entitled to be  treated as such under Companies Profits (Surtax) Act, 1964. The "forefeited dividends" do not represent "reserve". [417G-H; 418A-B]      Vazir Sultan Tobacco Co. Ltd. v. Commissioner of Income Tax, [  ]981] 132  ITR 559;  Metal  Box  Co.  Ltd  v.  Their Workmen, 73  ITR 53 at 67-68; and Commissioner of Income Tax (Central) Calcutta v. Standard Vaccum oil Co., 59 ITR 685 at 698 relied upon.      Commissioner of  Income-tax, Kanpur  v.  British  India Corporation (P) Ltd., 92 ITR 38 approved.      Commissioner of  Income Tax  v. Eyre  Smelting  Private Ltd., 118 ITR 857 referred to.

JUDGMENT:      CIVIL APPELLATE  JURISDICTION: Civil Appeal No. 1665 of 1974

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    From the  Judgment and  order dated  28.9.1973  of  the Allahabad High Court in I.T. Reference No. 195 of 1971.      With Civil Appeal No. 145 of 1976.      Dalip Singh,  K.C. Dua  and Miss  A. Subhashini for the Appellant.      Harish Salve,  K.J. John,  Ranjit Kumar  and B.P. Singh for the Respondent.      The Judgment of the Court was delivered by      SABYASACHI MUKHARJI,  J. These  two appeals  were heard together. Civil  Appeal No.  1665 of  1974 arises  from  the decision of  the  High  Court  of  Allahabad  in  Income-Tax Reference No. 195 of 1971.       The  assessee, Elgin Mills Ltd., at the relevant time, was a  public limited  company engaged  in the  business  of manufacture of  textile goods.  The assessment year involved is the  year 1964-65  of which  the relevant  previous  year ended  on   30th  September,   1963.  For  the  purposes  of assessment  under   the  provisions   of  Companies  Profits (Surtax) Act, 1964, a dispute arose between the assessee and the revenue  with regard  to the  computation  of  "Standard deductions". The  company claimed that the following amounts should be treated as 411 reserves for the purposes of computation of its capital:           (a) Investment Reserve-Rs.85,00,000           (b) Rehabilitation reserve-Rs.40,00,000           (c) Forfeited Dividend reserve-Rs.96,374      The Income-tax  Officer did not include any of the said ’reserves’ in  the capital  of the  assessee-company on  the basis that  these did  not represent  reserve  in  the  real sense. On  appeal, the Appellate Assistant Commissioner held that the  Rehabilitation  reserve  and  Forfeited  Dividends reserve represented  reserves  but  the  investment  reserve account did  not constitute  real reserve. Both the assessee as well  as  the  revenue  went  up  in  appeal  before  the Tribunal. The  Tribunal  disposed  of  these  appeals  by  a similar order along with two similar appeals relating to the assessment year 1963-64 which arose out of proceedings under the Super  Profits Tax Act, 1963. The Tribunal held that all the three  accounts represented reserves for the purposes of assessment under  the  Super  Profits  Tax  Act,  1963.  The Tribunal  was  further  of  the  view  that  all  the  three represented reserves  for the  purposes of  assessment under the Super  Profits  Tax  Act,  1963  and  as  the  principle involved  was  the  same  as  under  the  Companies  Profits (Surtax) Act,  1964, the  Tribunal held that the accounts in question represented  reserves under the latter Act also. At the instance  of the Commissioner, reference was made to the High Court  for the assessment year 1964-65 on the following questions:           "1. Whether, on the facts and in the circumstances           of the case, the tribunal was right in arriving at           its decision  by applying the principles laid down           in the  second schedule  to the  Super Profits Tax           Act, 1963, instead of the provisions of the second           Schedule to  the Companies  Profits (Surtax)  Act,           1964, for  computation of  capital of the assessee           company for the assessment year 1964-65.           2. Whether,  on the  facts and in the circumstance           of the  case, the  tribunal was  right in  holding           that (a)  Investment  Reserve  (b)  Rehabilitation           reserve  (c)   Forfeited  Dividend   Reserve  were           includible  in  the  capital  computation  of  the           company in  accordance with the second schedule to           the Companies Profits (surtax) Act, 1964."

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412      The High  Court noted  that in  the connected reference No. 196  of 1971-Commissioner  of Income-tax  v. Elgin Mills Company Ltd.  (decision dated  19th July, 1973)) arising out of proceedings under the Super Profits Tax Act, 1963, it had already held  that these  accounts in  question  constituted reserve in  the real  sense and as such should be taken into consideration in  determining the  standard deductions under section 9(2)  of the  Act, 1963.  It was not disputed before the High  Court that if the present reference had been under the Super  Profits Tax  Act, 1963,  the accounts in question would have  to be held as reserves by the High Court in view of its  previous judgment.  But it  was contended  that  the provisions of  the Companies Profits (Surtax) Act, 1964 were different from  the provisions  of the Super Profit Tax Act, 1963. The  High Court  did not  accept this  contention. The High Court  was of  the  view  that  under  both  the  Acts, charging sections (section 4) were identically worded except that the  expression "standard  deduction" in  Super Profits Tax Act, 1963 had been replaced by the expression "statutory deductions" in  the Companies  Profits (Surtax)  Act,  1964. Under both  Acts these  deductions had  to be  computed with reference to  the capital  employed in the assessee company. Under both  the Acts  reserves of  the company  were  to  be treated as  its capital  and the  only difference was in the second schedule to the Companies (Profits) Surtax Act, 1964, an explanation  had been  added. The said explanation was to the following effect:           "For the  removal of  doubts it is hereby declared           that any  amount standing  to the  credit  of  any           account in  the books of a company as on the first           day  of   the  previous   year  relevant   to  the           assessment year which is of the nature of item (5)           or  item   (6)  or  item  (7)  under  the  heading           "RESERVES AND  SURPLUS" or  of any  item under the           heading "CURRENT  LIABILITIES AND  PROVISIONS"  in           the column  relating to  "Liabilities" in the Form           "Balance Sheet"  given in part I of Schedule VI to           the Companies  Act, 1956 (I of 1956), shall not be           regarded  as   a  reserve   for  the  purposes  of           computation of  the capital of a company under the           provision of this schedule."      This  explanation,   the  High   Court  noted,   merely clarified what  was implicit  in the  Super Profit  Tax Act, 1963. Item  No. S  in the prescribed Balance Sheet under the Companies Act is "Surplus ’ i.e.      Balance in  profit and loss account after providing for proposed alloca- 413 tions, namely,  Dividend, Bonus,  or Reserves.  Item No. (6) was "Proposed  additions to  reserves" and  item No. (7) was "Sinking Funds".  The Accounts  mentioned in the explanation would not form a reserve for the purposes of the computation of capital  of a  company. In any case the High Court was of the view that none of the accounts in dispute fell under the heading "current  liabilities". It  was contended before the High Court on behalf of the revenue that any amount credited to those  accounts during  the relevant  previous year would fall in  item No. 6 viz. proposed additions to reserves. The High Court found that there were no additions to those funds during the  relevant previous  year inasmuch  as the  amount standing in  those accounts  were being brought forward from year to  year. In those circumstances the Tribunal was right in deciding the question with regard to the admissibility of the three  accounts in question on the principle application

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to Super  Profits Tax  Act, 1963. This Court in Vazir Sultan Tobacco Co.  Ltd. v.  Commissioner of Income Tax, [1981] 132 I.T.R. 559  held that  the expression  "reserve’.  in  Super Profits Tax  Act, 1963  and the  Companies Profits  (Surtax) Act, 1964 are in pari materia.      On merits,  it was  agreed that the points were covered by the  previous decision  of the  High Court in the case of Commissioner  of   Income-tax,  Kanpur   v.  British   India Corporation (P)  Ltd., 92  I.T.R. 38.  Accordingly, the High Court answered  both the questions in the affirmative and in favour of  the assessee.  This appeal arises out of the said decision of  the High  Court. In Commissioner of Income-tax, Kanpur v.  British India  Corporation (P)  Ltd. (supra), the High Court  noted the  distinction between  ’provision’  and ’reserves’ and  observed that  when an  amount was set apart for a  future liability, it was called a reserve and when it was set apart to meet an existing liability, it was called a provision. The  High Court was of the view that the Tribunal in that  case was  right in  holding that  capital  reserve, stocks and stores reserves, bad and doubtful debts reserves, obsolescence  reserve,  loans  and  insurance  reserves  and investment reserves  were to  be included in the computation of  capital.  The  Tribunal  was  not  right  in  including, according to  the High Court, forfeited money reserve as the assessee had  been transferring  to this  account  dividends which had not been collected by the share holders after they had been  declared, and  as and when the shareholders made a claim, made  payments and  debited the  same to the account. The High Court, therefore, was of the view that this account represented a provision in respect of an existing liability.      The High  Court in Income-Tax Reference No. 196 of 1971 had to 414 deal with investment reserve account, rehabilitation reserve account, capital  reserve account  and depreciation  reserve account and  held that  these were  reserves but the account maintained as dividend account did not represent reserve.      The High  Court in  its judgment noted that on the 19th July 1973  relying on other judgment in Income-Tax Reference No. 200  of 1917  Commissioner of  Income-Tax v.  The  Saran Engineering Co.  Ltd. had  answered the  question by  saying that the aforesaid items were re serves. This is the subject matter of  civil appeal  No. 1599 of 1974 which will also be disposed of by another judgment of this Court.      Civil Appeal  No. 1665 of 1974 and Civil Appeal No. 145 of 1976  which arose out of the Income-Tax Reference No. 196 of 1971  have been  heard together and are being disposed of by this judgment.      In this  connection it would be desirable to dispose of Civil Appeal  No. 145  of  1976  separately  first.  It  was submitted  that   the  assessee   had   shown   capital   of Rs.2,63,79,218  which   included  the   aforesaid   reserves including  investment   reserves,  rehabilitation   reserve, capital  reserve,   depreciation   reserve   and   forfeited dividends. The  submission on  behalf of the revenue by Sree Dalip Singh  was that  the amount  of  Rs.85  lakhs  in  the relevant year  as investment  reserve was  set apart  by the assessee company  to meet the liabilities of its Bombay Sub- sidiaries, M/s  Madhav Mills Ltd. and Calico Processors Ltd. which were known to the assessee on the date of the balance- sheet. The Directors’ report, according to the revenue, left no room  for doubt that these were anticipated losses of the assessee company  in the form of the investments made in its Bombay subsidiaries  known at the date of the balance sheet. These were  liabilities, according  to Sree  Singh  actually

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staring in the face of the assessee company when it prepared the balance  sheet. The  Tribunal had  held that  it  was  a reserve because it was formed by transfer of the amount from capital/General reserve.  This  according  to  the  revenue, could not  be accepted.  Revenue submitted  that  it  was  a common ground  that originally  the amount was set apart out of the  undistributed mass  of  profits  and  therefore  the moment it  was taken  out of the capital or general reserve, it ceased  to be  a capital  or general reserve, and but for its  being   set  apart  to  meet  the  liabilities  of  its subsidiaries, it  had again gone back and formed part of the undistributed  mass  of  profits  and  thereby  assumed  its original character.  It was  submitted that  the reserve  in order that  it might  be so  called in the real sense of the term must come out of the profits of the 415 company. But  if reserves  were constituted  out  of  assets which were  sold A  or  by  any  other  means  it  would  be difficult to  term the  amounts shown  as  reserve.  It  was submitted that  the investments  by the  assessee company in the Bombay  subsidiaries were  in  the  nature  of  bad  and doubtful debts.  Therefore, these  were dead  losses of  the assessee company  as the  holding company, and these amounts were ultimately  bound to  be writ- ten off and according to the  revenue’s  submission,  the  substance  of  the  matter clearly was that the amount of RS.85 lakhs though shown as a reserve, was,  in fact,  a provision to meet the anticipated losses or bad and doubtful debts in the shape of investments in the  two subsidiaries  aforesaid which  were shown at the date of the balance sheet.      For the  assessee Sree  Salve drew our attention to the distinction between  reserve and  provision which  has  been discussed in  the decision  of this  Court in  Metal Box Co. Ltd. v. Their Workmen, 73 I.T.R. 53 at 67-68.      According to  the revenue, the nature and object of the subsidiary companies  have  to  be  kept  in  view  and  the practical result,  revenue contended before us, was that the shareholders of  the holding company whose share capital had been employed for the floatation of the subsidiary companies had not  only no  power  to  control  the  dealings  of  the subsidiary companies  but in  fact had  no knowledge of, nor any right  to the knowledge of or dealings of the subsidiary companies.      The expressions  ’Provision’ and  ’Reserve’ are defined in Schedule  VI Part  III to the Companies Act, 1956. In the decision of this Court in Vazir Sultan’s case (supra) it has been held  that a  provision was  meant to  provide for  any known liability  and the  substance of  the matter had to be kept in  view. It  was further  submitted by Sree Singh that the depreciation  reserve could  not  be  considered  to  be reserve in  the  real  sense  at  all.  Forfeited  dividends reserve of R.S.. 1,08,771 had to be a provision.      On the  other hand,  on behalf  of the  revenue, it was submitted that in order to constitute reserve, there must be an appropriation of profits current or accumulated and not a charge against  the profits  for the  year. The conduct must bear out  the intention  to create a reserve. It must not be to set  apart to meet any known liability, a liability known but  existing   on  the   date  of  the  balance-sheet.  The explanation ’reserve’  has been defined in the text books of Accountancy which has been noted by this Court. It was urged that it could not be disputed 416 that reserve  might be general or specific reserve, what was required was that amount should be kept aprat for one or the

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other purpose  either general  or specific.  The distinction between provision  and reserve  must be found out bearing in mind main  features of the reserve. These are (1) It must be an appropriation  of profits, current or accumulated and not a charge  against the  profits for the year. (2) The conduct of the parties must bear out that intention. (3) It must not be to  set apart  to meet  any known  liability-a  liability known to  exist on  the date of the balance sheet. Reference in this  connection may  be made to the observations of this Court in  Vazir Sultan’s  case (supra)  at pages 569-70. The Calcutta High  Court in  Commissioner of  Income Tax v. Eyre Smelting  Private   Ltd.,  118   I.T.R.   857,   noted   the characteristics of  ’provisions’ as  well as  ’reserves’. It held,  inter   alia,  that   provisions  were  made  against anticipated losses  and contingencies,  it held further that an amount  set aside  of the  profits  designed  to  meet  a contingency or  liability or commitment or diminution in the value of  the assets  known to exist would be a reserve, and an amount  set aside  to provide  for a  known liability  to which the  amount  cannot  be  determined  with  substantial accuracy would  be a provision. The said High Court differed from the  decision of  the Allahabad  High Court  in British India Corporation  (P) Ltd.  (supra) in  respect of ’bad and doubtful debts.’  Whether in  respect of  bad  and  doubtful debts the  account could  be treated as reserve or provision would depend upon the facts and circumstances of the case.      The distinction  between ’provision’  and ’reserve’ has been clarified  by this  Court in Metal Box Company of India Ltd. v. Their Workmen (supra) at pages 67-68 which states as follows:           "The  next  question  is  whether  the  amount  so           provided  is   a  provision   or  a  reserve.  The           distinction between  a provision  and a reserve is           in  commercial   accountancy  fairly  well  known.           Provisions made  against  anticipated  losses  and           contingencies are  charges  against  profits  and,           therefore, to  be taken into account against gross           receipts in  the P.  & L. account and the balance-           sheet.  On   the   other   hand,   reserves   are,           appropriations of  profits, the  assets  by  which           they are  represented being  retained to form part           of  the   capital  employed   in   the   business.           Provisions are  usually shown in the balance-sheet           by way of deductions from the assets in respect of           which they  are made  whereas general reserves and           reserve  funds   are  shown   as   part   of   the           proprietor’s interest 417           (see  Spicer   and   Pegler’s   Book-keeping   and           Accounts, 15th  A Edition, 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  pro-  vide  for  any  known           liability of which the amount cannot be determined           with substantial  accuracy is  a  provision:  (see           William Pickles  Accountancy, second  edition,  p.           192; Part  III,  clause  7,  Schedule  VI  to  the           Companies Act,  1956: which  defines provision and           reserve)."      This Court  in Commissioner  of  Income  Tax  (Central) Calcutta v.  Standard Vaccum  oil Co., 59 I.T.R. 685 at 698, observed that the ordinary meaning of the expression reserve

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was something specifically kept apart for further use or for specific occasion.  The observations  made therein will have to be understood in the light of the subsequent decisions of this Court in Metal Box (supra) and Vazir Sultan (supra).      This Court  in Vazir  Sultan Tobacco  Co. Ltd.  etc. v. Commissioner  of  Income-tax  etc.  (supra)  considered  the expression ’reserve’  in the Super Profits Tax Act, 1963 and Companies (Profit)  Surtax Act, 1964. It is not necessary to set out all the conclusions of this Court.      Our attention  was drawn  to Datta’s on the Company Law (Third  Edition)   at  page  42  1.  "Reserves"  consist  of appropriations from  profits and  other surplus and retained for future  use. This,  however, does not include any amount which had  been kept  to meet any liability or diminution in value of assets known to exist as on the date of the balance sheet. The  essence and  substance of  the matter  has to be kept in view.      As   reiterated   before,   the   distinction   between ’provision’ and  ’reserve’ is  while the  ’provision’  is  a charge of  profits which are taken into account in the gross receipt  of   Profits  &   Loss  Account,  ’reserve’  is  an appropriation of  profit to  provide for  the asset which is represented.      Keeping these  tests and  the facts of these appeals in mind, we  must hold that the conclusion of the High Court in Civil Appeal  No. 1665  of 1974  holding that the investment reserve and  rehabilitation reserve  were reserves  and were entitled to  be treated  so under the relevant Act is right. But in the facts of the case, the High Court was 418 not right in holding that the forfeited dividend reserve was reserve and  question No.  2 also  in  the  affirmative.  It should have  followed in  this respect its previous decision in respect  of forfeited dividend reserve in Commissioner of Income-Tax v. British India Corporation (supra). The appeal, therefore fails,  except on the point of "Forfeited Dividend Reserve."      In Civil  Appeal No. 145 of 1976, we are concerned with five   items   as   mentioned   i.e.   investment   reserve, rehabilitation  reserve,   capital   reserve,   depreciation reserve and  forfeited dividends  and in  view of  the facts found,  we   are  of  the  opinion  that  first  four  items constituted reserves and were entitled to be treated as such under the  Act and the forfeited dividends did not represent reserve. This  appeal accordingly fails in view of the facts found by  Tribunal and  reiterated by the High Court and the principles applicable  as mentioned  hereinbefore. The  High Court in its order had excluded "Forfeited dividend account" from the reserve. The High Court was right in so doing.      In the facts and circumstances of the case, the parties will pay and bear their own costs in both the appeals.                                  CA 1665/74 allowed in part. M.L.A.                                  CA 145/76 dismissed. 419