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PETITIONER: PURSHOTAM H. JADYE AND OTHERS

       Vs.

RESPONDENT: V. B. POTDAR

DATE OF JUDGMENT: 26/10/1965

BENCH: GAJENDRAGADKAR, P.B. (CJ) BENCH: GAJENDRAGADKAR, P.B. (CJ) WANCHOO, K.N. HIDAYATULLAH, M. RAMASWAMI, V.

CITATION:  1966 AIR  856            1966 SCR  (2) 353

ACT:  Business Profits Tax Act, 1947- Schedule 11, rules 2(1) and (3)"Premium’ and "reserves" in computation of capital  under r. 2(1)Whether cover accounts described as "capital paid  in surplus"   and  "Earned  Surplus"  according   to   American accounting practice.

HEADNOTE: The  assessee  company  was incorporated  in  the  State  of Delaware in the United States of America with the object  of taking  over the assets of two other American  companies  in return  for  stock  in  the  assessee  company.   Upon   the acquisition,  although  the book value of the  assets  taken over   from  each  of  the  two  transferor  companies   was different, the two cornpanies were allotted an equal  number of shares in the assessee company.  Part of this  difference was covered by issuing serial bonds ,to one of the companies which  were late redeemed.  As the total book-value  of  the assets  taken over by the assessee company was in excess  of the  par  value of the stock issued to  the  two  transferor companies,  this  excess,  in  accordance  with  established accounting  practice  in the United States of  America,  was entered  in the books of the assessee company in an  account styled "Capital paid in Surplus". The net profits earned by the assessee company from year  to year,  after certain appropriations, were also in line  with American  accounting  practice, shown in the  balance  sheet under   the   caption   "Earried   surplus"   or   "Earnings reinvested". In  proceedings  for assessment under s. 4 of  the  Business Profits Tax Act, 1947, the Income Tax Officer disallowed the claim  of  the  assessee company for the  inclusion  of  the accounts  "Capital paid in Surplus" and "Earned Surplus"  in the computation of taxable capital under Schedule IT r. 2(1) of  the Act and the Appellate Assistant Commissioner  agreed with  him.   But  the Tribunal, in  appeal,  held  that  the difference  between the value of the assets taken  over  and the  value  of  stock issued by  the  assessee  company  was premium  realised from the issue of its shares and  retained in the business within the meaning of rule 3 of Scb. 11  and

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was  in any event reserve not allowed in  computing  profits within the meaning of r. 2(1).  The Tribunal also held  that the "Earned Surplus" represented reserves liable to be taken into  account  in assessing business profits  tax.   Upon  a reference,  the  High  Court agreed with the  views  of  the Tribunal. It  was contended on behalf of the Revenue, inter alia,  (i) that shares may be said to-)be issued at a premium only when they  were  issued for cash in excess of par value  and  not otherwise; (ii) that the amount of "Capital paid in Surplus" could  not  be  regarded  as  "reserves’  as  the   reserves contemplated  by r. 2(1) are only those which are built  out of  profits processed for the purpose of taxation under  the Indian  income-tax Act and that where a reserve  is  brought into existence by creating or increasing, by revaluation  or otherwise  a  book  asset,  it cannot  be  included  in  the computation of capital by virtue of the Explanation to r. 2; (iii)  that the: "Earned Surplus" in the balance  sheets  of the asessee company Sup.  CI/66-10 368 were  not  reserves, as accumulated profits  could  only  be deemed  reserves within the meaning or r. 2(1) if they  were specifically allocated to reserves and not otherwise. HELD:     (i)  The High Court was right in holding that  the difference between the book value of the assets  transferred and the par value of capital stock was premium. [376 E] In  the  absence of any restriction in the law  of  Delaware against  the issue of shares otherwise than for  cash,  when shares  were issued for consideration other than  cash,  the value  of assets transferred in excess of the par  value  of shares  issued  would  be regarded as  "premium’  under  the Indian system of law. [374 F] When shares are issued at a premium, ordinarily premium at a uniform  rate  would  be charged  from  all  applicants  for shares;  but  on  principle there is  no  objection  to  the charging of varying rates of premium for shares issued under a  single  resolution, if all the parties  concerned  agree. In  the present case although the book value of  the  assets transferred by the transferor companies was larger than that of  the assets transferred by the other company,  these  two companies agreed with the assessee company to receive stocks of equal par value carrying equal rights. [374H; 375E] Shares  at  or  without premium may  be  issued  subject  to express  statutory  provision to the contrary for  money  or services or in consideration of transfer of property.  There was  no  provision in the companies Act, 1913, nor  was  any shown  in a statute in the State of Delware which enacted  a different rule. [376 A-B] (ii) The   amount   of  "capital  paid  in   surplus"   also represented "reserves" within the meaning or r. 2(1). Reserves  built up from sources other than profits would  be admissible for inclusion in capital under r. 2(1) Commissioner  of  Income-tax, Bombay v. Century  Spinning  & Manufacturing Co. Ltd., 24 I.T.R. 499, referred to. Difference  between the assets received by the  company  and the  par  value of the shares issued was not  a  book  asset "brought  into  existence  by  creating  or  increasing  (by valuation  or  otherwise)".  These assets  received  by  the assessee company were real and tangible and it was only  for accountancy purposes that a part of the value of assets  was allocated to the par value of the shares and the balance  to the "Capital paid in Surplus" account. [378 A-D] (iii)     The  High  Court  was right in  holding  that  the "Earned   Surplus"  in  the  assessee   company’s   accounts

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represented "reserves" within the meaning of r. 2(1). In accordance with accountancy practice in the United States of  America, the balance of net profits after allocation  to specific reserves and payment of dividend is entered in  the account  under  the  caption  "Earned  Surplus"  and  it  is intended thereby to designate a fund which is to be utilised for  the  purpose  of  the business.  Such  a  fund  may  be regarded  according  to  the  Indian  practice  as  "general reserves". First  National  City Bank v. Commissioneer  of  Income-tax, Bombay, 42 I.T.R. 17, referred to. The accounts of the assessee company maintained according to the  general accountancy practice prevailing in  the  United States of America                             369 disclosed that the balance of "Earned Surplus" it the end of the  year did not merge into the account of  the  subsequent year.   It  represented a specific account into  which  were added  the net profits of the year and  appropriations  were made  out  of  it and the balance was  regarded  as  "Earned Surplus"  at  the  end  of  the  year.   This  account   was specifically  allocated for utilisation for the  purpose  of the  business  year after year.   Therefore  the  conditions regarded   as   essential   in  the   Century   Spinning   & Manufacturing   Company’s  for  constituting  the,   "Earned Surplus" into reserves" were fulfilled. [379G-383E-G]

JUDGMENT: CIVIL APPELLATE JURISDICTION : Civil Appeal No. 268 of 1964.  Appeal  by special leave from the judgment and order  dated January  29, 1962 of the Calcutta High Court  in  Income-tax Reference No. 1.8 of 1955. A.   V. Viswanatha Sastri, N. D. Karkhanis, R. H. Dhebar and R.   N. Sachthey, for the appellant. N.   A.  Palkhiwala, Ramachandran, J. B. Dadachanji,  O.  C. Mathur and Ravinder Narain, for the respondent. The Judgment of the Court was delivered by Shah,  J. At the instance of the Commissioner of  Income-tax (Central)   Calcutta,  the  Income-tax  Appellate   Tribunal referred the following questions for the opinion of the High Court of Calcutta under s. 19 of the Business Profits Act 21 of 1947 :               "(1)  Whether on the facts found the  Tribunal               was   right  in  holding  that  the   sum   of               $117,000,000 appearing in the Balance Sheet of               the  assessee Company under the head  "Capital               paid  in Surplus" and constituting the  excess               of the book value of the assets over the  face               value   of  the  shares  represented   premium                             realised  from  the  issue  of  the  s hares  as               contemplated  by Rule 3 of Schedule II of  the               Business Profits Tax, Act, 1947.               (2)   Whether    on   facts   and    in    the               circumstances  of  the case the  Tribunal  was               right in holding that the fact that the amount               in  question had been built up out of  capital               and not out of taxed profits would not prevent               it from being reserve as contemplated by  Sub-               Rule  (1) of Rule 2 of the Schedule 11 of  the               Business Profits Tax Act.               (3)   Whether   on  the  facts  and   in   the               circumstances  of the case, the  Tribunal  was

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             right  in holding that the sum of  $29,000,000               odd,  $43,000,000  odd,  $56,000,000  odd  and               73,000,000  &  odd for  the  respective  years               appearing   in  the  Balance  Sheets  of   the               assessee as,               370               "Earned Surplus" would be treated as a reserve               within  the meaning of Sub-Rule (1) of Rule  2               of the Schedule 11 of the Business Profits Tax               Act." The  High Court recorded answers in the affirmative  on  all the questions.  The Commissioner of Income-tax has  appealed to this Court with special leave., The assessee Company is a non-resident.  It was incorporated in  the  State of Delaware in the United States  of  America with the object of taking over the assets of two  companies- Socony  Vacuum  Oil Company and Standard  Oil  Company  (New Jersey).    The   capital  of  the  assessee   company   was $10,000,000 divided into 100,000 shares of the value of $100 each.   On  the date of acquisition the book values  of  the assets  of the two companies as recorded in their  books  of account were: Socony Vacuum Oil Company.... $97,715,701 Standard Oil Company                     (New Jersey).... $46,767,397 In  consideration of transfer of these assets, the  assessee company allotted to each company 49,995 shares and to Socony Vacuum Oil Company serial bonds of the value of $13,093,000. The  remaining ten shares were divided equally  between  the two  transferor  companies  for  cash  at  par  value.   The assessee  company entered in its books of account  the  book value   of  the  assets  taken  over  from  the   transferor companies.   The  excess of the net value of the  assets  so transferred  over the par value of the stock issued and  the serial  bonds was entered in the books in an account  styled "Capital  paid in Surplus".  The serial bonds issued to  the Socony   Vacuum  Oil  Company  were  later   redeemed.    By adjustment entries the "Capital paid in Surplus" account was reduced  to $117,561,317 and throughout the period of  three years  to which these appeals relate, in the balance  sheets of the assessee company, the "Capital paid in Surplus" stood unchanged  at  that figure.  The net profits earned  by  the Company  year after year, subject to certain  appropriations were  shown in the balance sheet under the  caption  "Earned Surplus" or "Earnings reinvested".  At the end of 1945,  the balance  of "Earned Surplus" was $29,557,597 and by the  end of 1948 the account stood at $73,766,592. The Income-tax Officer disallowed the claim of the  assessee Company  for  inclusion  of the accounts  "Capital  paid  in Surplus" and "Earned Surplus" in the computation of  taxable capital  under Sch.  II r. 2(1) of the Business Profits  Tax Act and the Appellate 37 1 Assistant Commissioner agreed with him.  But the  Income-tax Appellate  Tribunal  held that the  difference  between  the value  of the assets taken over and the value of  stock  and serial  bonds  issued by the assessee  Company  was  premium realized  from the issue of its shares and retained  in  the business  within the meaning of r. 3 of Sch.  II and was  in any  event reserve not allowed in computing  profits  within the  meaning  of r. 2(1).  The Tribunal also held  that  the amount  entered in the account "Earned Surplus" was  reserve liable  to  be  taken into  account  in  assessing  business profits  tax.   In a reference under S. 19 of  the  Business Profits Tax Act, the High Court agreed with the view of  the

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Tribunal on the three questions referred for its opinion. The provisions of the Business Profits Tax Act, 1947,  which have  a bearing on the questions raised in the reference  to the High Court may first be summarised By s. 4 of the Act in respect  of any business to which the Act applies,  business profits  tax  is  charged, levied and paid  on  the  taxable profits during any accounting period at the rates  specified in the Act.  The expression "Taxable profits" is defined  in s.  2(17)  as  the  amount by which  the  profits  during  a chargeable accounting period exceed the abatement in respect of that period.  "Abatement" is defined in s. 2(1)  (insofar as it is material) as meaning, in respect of any  chargeable accounting  period  ending on or before the 31  st  day  of. March,  1947 a sum which bears to a sum equal to (a) in  the case  of  a  company, not being a  company  deemed  for  the purposes  of s. 9 to be a firm, six per cent of the  capital of the company on the first day of the said period  computed in  accordance  with  Sch.   II,  or  one  lakh  of  rupees, whichever  is greater, and (b) in respect of any  chargeable accounting  period  beginning after the 31st day  of  March, 1947,  such sum as may be fixed by the annual  Finance  Act. Schedule  II  prescribes rules for the computation  "of  the capital of a company for purposes of business profits  tax". The material clauses are 2(1) and 3 :               "2. (1) Where the company is one to which rule               3 of Schedule I applies, its capital shall  be               the  sum of the amounts of its  paid-up  share               capital and of its reserves in so far as  they               have not been allowed in computing the profits               of the company for the purposes of the  Indian               Income-tax Act, 1922 (XI of 1922),  diminished               by the, cost to it of its investments or other               property   the  income  from  which   is   not               includable in the profits, so far as that cost               exceeds any debt for money borrowed by it.               (2)....................................               372               Explanation.-A   reserve  or   paid-up   share               capital brought into existence by creating  or               increasing  (by revaluation or otherwise)  any               book asset is not capital for the purposes  of               ascertaining  the abatement under this Act  in               respect of any chargeable accounting period.               3.    So  much  of the premium realised  by  a               company from the issue of any of its shares as               it retained in the business shall be  regarded               as forming part of its paidup capital for  the               purposes of rule 2." The  first two questions referred by the Tribunal relate  to the  true  nature  of the amount entered  in  the  books  of account  of the assessee company under the caption  "Capital paid  in  Surplus".  It is a common practice in  the  United States  of America in transactions in which business  assets are  transferred to a new company, to issue shares of  total par   value  less  than  the  true  value  of   the   assets transferred.   Singer, who was Treasurer of Standard  Vacuum Oil  Company and officiated as Treasurer and later as  Vice- President of the assessee Company has stated in  paragraph-5 of his affidavit that.  "The reason for limiting the  stated or  par  value of the capital stock of Standard  Vacuum  Oil Company  to  $10,000,000 rather than  including  the  entire capital of $131,391,098.71 in the par value of issued  stock was simply to reduce issuance taxes and fees payable on  the basis of the par value of stock issued, in view of the  fact that  the stock was held by only two corporate  shareholders

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and  there was no need for a larger number of shares  to  be issued   and  outstanding."  In  "Cases  and  Materials   on Corporations" by Dodd and Baker, 2nd Edn., at p. 1118  under the  head  "Sources  of Capital Surplus"  the  authors  have stated               "Credits to an account that is still generally               called  Paid-in Surplus arise in a  number  of               circumstances which include: (a) where  shares               having a par value including the very low  par               value  that  has recently come into  use,  are               issued   and   sold  for  cash   or   non-cash               consideration  in  an  amount  in  excess   of               part.........  The occasion for the issue  may               be  an  initial or subsequent  acquisition  of               property.  Such a property acquisition may  be               the  purchase  of  all  or  substantially  all               assets  of  another  corporation  as  a  going               concern,  or  a merger by which  such  another               corporation  is  absorbed  by  the   surviving               corporation,  or a consolidation by which  two               or  more  corporations are absorbed by  a  new               corporation   created  in  the   consolidation               proceedings.  Upon such a purchase                                    373               of assets or in a merger or consolidation, the               defensible  value of the assets of the  vendor               or of the absorbed corporation or corporations               may  not be "capitalized" in its entirety,  so               that  a  paid-in  surplus  emerges  from   the               transaction." In  Fletcher’s  Cyclopedia Corporations  Vol.  19  Paragraph 9237,  the  author  has set out  the  prevailing  method  of carrying into the balance sheet the amount of  consideration received in excess   of par value under the head "Surplus" :               "........as dividends can be declared only out               of  surplus  earnings, and there  must  be  an               exact  method of determining  whether  surplus               earnings  for that purpose actually exist,  it               is  the  view  of sound  attorneys  and  sound               accountants  that  the only proper  method  of               handling, in the accounts, the item of no  par               value  stock is to set up on the books,  as  a               charge  against  capital, the  amount  of  the               consideration received for each issue of  such               stock  and  that any other  increases  or  any               decreases  in net assets should be carried  on               the  balance  sheet  under  the  headings   of               Surplus  and Deficit, just as if  the  capital               charge  had been made in connection  with  the               issuance  of stocks having a par value.   They               will therefore keep the capital stock entry  a               constant  figure, representing the  amount  of               consideration  received for the same, and,  if               the corporation earns money, they will set up,               on the liabilities side of the ’balance  sheet               an   item   which  they  call   "Surplus"   or               "Undivided  Profits."                       If               additional  no  par  value  stock  is  issued,               although,  under  the theory of no  par  value               stock, it need not be issued at the same price               as the original issue but at such price as the               directors   determine  to  be  for  the   best               interests  of the corporation, the  number  of               shares  issued will be added to the number  of               shares   outstanding  and  the   consideration

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             received  for  the same will be added  to  the               figures  opposite the entry  "Capital  Stock,"               and thereafter the entry of capital stock will               continue   to   be  a   constant   item,   the               adjustments for earnings or losses being  made               in the accounts of "Surplus" or "Deficit"               It is also stated :               "In  some  of the States the  legislature  has               introduced a complication by writing into  the               statutes which               374               provide  for  the  issuance of  no  par  value               shares a provision "that, in setting up the no               par value stock on the books, a portion of the               consideration received therefor may be charged               to "Stated Capital" and a portion to  "Paid-In               Surplus".               Under  the statutes of Michigan, the  item  of               "PaidIn-Surplus"   must  be  carried  on   the               balance sheet as a separate item from  "Earned               Surplus"  or "Undivided Profits," and such  is               the policy of many accountants in the  absence               of any statutory provision." Therefore  stock is issued in consideration of  transfer  of assets,  the par value of stock is not necessarily equal  to the value of assets transferred.  Where the value of  assets transferred  exceeds  the  par  value,  the  difference  may appropriately  be  regarded as "premium"  according  to  the nomenclature used in India. Under  the Companies Act, 1913, shares could be  issued  for cash or against transfer of property, and it is not  claimed that  under  the  statute law in the  State  of  Delaware  a different  rule  prevailed  at the time  when  the  assessee company  took over the assets of the  transferor  companies. The  Indian Companies Act also places no restriction upon  a company issuing shares for a consideration which exceeds the par  value  of the shares, and there is no evidence  on  the record  that  in  the  State of Delaware  there  is  such  a restriction.  A share is not a sum of money : it  represents an  interest  measured  by a sum of money  and  made  up  of diverse  rights contained in the contract evidenced  by  the articles  of association of the Company.  In the absence  of any restriction in the law of Delaware against the issue  of shares  otherwise than for cash, when shares are issued  for consideration  other  than  cash the  value  of  the  assets transferred  in  excess of the par value  of  shares  issued would  be regarded as premium for purposes of our system  of law.   No  serious argument has been advanced before  us  on behalf  of the Commissioner controverting this part  of  the case. When  shares  are  issued  to  the  public  at  a   premium, ordinarily  premium at a uniform rate would be charged  from all applicants for shares.  But that is not because the  law contains  any  prohibition  against  charging   differential premiums.  The right of a company to charge varying premiums in respect of blocks of shares having the same rights issued under different resolutions is not denied, and on  principle there is no objection to the 375 charging of varying rates of premium for shares issued under a  single  resolution, if all the parties  concerned  agree. The  amount  or  value  which a person  intending  to  be  a shareholder may pay in excess of the par value for acquiring the  shares of a company depends upon the  contract  between the company and such a person.

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In the case under review, the two transferor companies  were willing to combine into a larger corporation, presumably  to avoid competition.  The book value of the assets transferred by Socony Vacuum Oil Company was undoubtedly larger than the book  value  of  assets  transferred  by  the  Standard  Oil Company.  But for effectuating a combine, the two transferor companies in a contract with the assessee company agreed  to receive  stocks of equal Oar value carrying equal rights  in consideration of transfer of assets of different values.  If the  excess  paid by the transferor companies over  the  par value of the shares received may be regarded as premium, and we hold that it does, it is not necessary to enter into  the correctness  of the submission of the assessee company  that the difference in the value of the assets transferred by the two companies was nominal, because the Standard Oil  Company had  transferred valuable "intangible assets" which had  not entered  into  the book valuation of its assets,  and  which bridged  the  difference  between the value  of  the  assets transferred  by that company and the assets  transferred  by the Socony Vacuum Oil Company. Under  the  Companies Act, 1913, shares of a  class  already issued  could be issued by a company at a discount,  subject only  to the conditions prescribed by s. 105A.  But the  Act made  no  provision  relating to the issue of  shares  at  a premium.   The matter was one governed by  contract  between the  company and the intending acquirer of shares.   In  the Companies  Act 1 of 1956, certain restrictions  are  imposed upon the application of premiums received on issue of shares by  s.  78.  Shares could therefore be issued at  a  premium under  the Act of 1913 and that appears to be recognised  by the terms of s. 78(3) of the Companies Act of 1956. It was found by the Tribunal that the amount entered in  the balance  sheet as "Capital paid in Surplus" was retained  in the business of the assessee company, and the correctness of that  view  was not challenged before the High  Court.   The only argument advanced before the High Court on this part of the  case  was that shares could be said to be issued  at  a premium only when 376 they were issued for cash in excess of the par value and not otherwise.   But  shares may be issued  subject  to  express statutory provision to the contrary for money or services or in  consideration of transfer of property, and there  is  no reason  to think that a different rule applies  when  shares are  issued  at  a premium.  There is no  provision  in  the Companies Act of 1913, which enacts a different rule, and it is not said that there is a statute in the State of Delaware which enacts a different rule. Counsel  for the Revenue maintained that the use of the  ex- pression "premium realised from the issue of any shares"  in r.  3  of  Sch. 11 implies that there  must,  prior  to  the allotment of shares under which premium is charged, be  some arrangement  for payment of consideration in excess  of  the par value of shares, and in the absence of evidence to prove such  an  arrangement, the capital surplus  is  not  premium realised  from the issue of shares.  No such contention  was raised at any stage in these proceedings, and a finding that there  was  before  the shares were  issued  an  arrangement between  the  two  transferor  companies  and  the  assessee company  that the shares were to be issued in  consideration of the transfer of assets of unequal book value held by  the two  transferor  companies is clearly implicit in  the  view expressed  by  the Tribunal.  The High Court  was  therefore right in holding that the difference between the book  value of the assets transferred and the par value of capital stock

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issued was premium. The  assessee  company  said that even  if  this  amount  of "capital paid in Surplus" be not regarded as premium  within the  meaning  of  r. 3, it is still  "reserves"  within  the meaning  of r. 2(1).  This plea found favour with  the  High Court.   Counsel  for  the Revenue  raised  two  contentions against acceptance of that view of the High Court : (1) that reserves  contemplated by r. 2(1) are only those  which  are built  out of profits processed for the purpose of  taxation under  the  Indian  Income-tax Act; and  (2)  that  where  a reserve is brought into existence by creating or increasing, by  revaluation  or  otherwise a book asset,  it  cannot  be included  in  the  computation  of  capital  by  virtue   of Explanation to r. 2. In support of his first contention  Mr. Vishwanath  Sastri relied upon the observations  of  Chagla, C.J.  in Commissioner of Income-tax v. Century Spg.  &  Mfg. Company Ltd.(1) In that case the Bombay High Court held that profits  of a company not allocated to any specific head  in the  balance  sheet at the end of the year of account  of  a company may be treated as "reserves" for the purpose of r. 2 of Sch.  II of the Business Profits Tax Act, but (1)  20 I.T.R. 260. 3 77 the  judgment of the Bombay High Court was reversed by  this Court:  video, Commissioner of Income-tax,, Bombay  City  v. Century  Spg.  &  Mfg.  Co. Ltd.(-’).  The  profits  of  the company had been subjected to tax, and the, question whether an  account which is built up otherwise than out of  profits of  the  business  could be regarded  as  reserves  for  the purpose  of  r. 2 did not fall to be decided in  that  case. Under  r. 2(1) reserves which insofar as they have not  been allowed  in computing the profits of the Company enter  into the computation of capital for the purpose of r. 2(1).  This Court observed In Century Spinning & Manufacturing Company’s case(1) :-               "Two essential characteristics must be present               before  the assessee can avail himself of  the               benefit  of the rule, namely, that the  amount               should not have been allowed in computing  the               profits  of  the company for the  purposes  of               Income-tax Act and that it should be a reserve               as contemplated by the rule." Rule 2 does not expressly say that the reserve admissible in the  computation  of  capital should be  one  built  out  of profits,,  and  this  Court did not suggest  that  the  rule contained such an implication.  Observations made by Chagla, C.J. in Century Spinning & Manufacturing Company’s cave 2  ) at p. 264 :               "Therefore  in order to determine the  capital               of  the company for the purposes of  this  Act               you have got to take the paid-up share capital               of the company, then you have to add to it the               reserves  and  you  have  to  add  only  those               reserves   which   have  been   subjected   to               taxation"               and at p. 265               "A  reserve in. the sense in which it is  used               in  Rule  2 can only mean profit earned  by  a               company  and not distributed as  dividends  to               the   shareholders  but  kept  back   by   the               Directors  for any purpose to which it may  be               put in future", were  only  made in reference to the facts of the  case  and were  not intended to lay down that reserves built  up  from sources  other  than  profits will  not  be  admissible  for

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inclusion  in capital under r. 2(1) of the Business  Profits Tax Act.  This contention is also negatived by the terms  of the  Explanation.   Reserves  which  may  be  brought   into existence by creating or increasing (by reevaluation (1) 11 54] S.C.R. 203. (2) 2) I.T.R. 260. 378 or  otherwise) any book asset are expressly declared  to  be not  capital for the purpose of ascertaining the  abatement. If  reserves  which  were  built not  out  of  profits  were excluded  from  the  operation of r.  2(1),  it  was  hardly necessary to enact the Explanation. The  Explanation  to r. 2 has no relevance  in  the  present case.   The  difference between the assets received  by  the company  and  the par value of the shares issued  cannot  be called  a book asset "brought into existence by creating  or increasing  (by  reevaluation or  otherwise)".   The  assets received  by  the  assessee company are  real  and  tangible assets.  It is only for accountancy purposes that a part  of the value of the assets is allocated to the par value of the shares  and the balance to the "Capital Surplus brought  in" account.  The High Court was therefore right in holding that the  account "Capital Surplus brought in the  balance  sheet represents  premium  realised from the issue of  its  shares within the meaning of r. 3, or in the alternative represents reserves not allowed in computing the profits of the company for the purpose of the Indian Income-tax Act, 1922. The next question is whether "Earned Surplus" may be treated as  "reserves" within the meaning of sub-r. (1) of r.  2  of Sch.  11.   It  is found by the Tribunal  that  the  profits earned year after year by the assessee company were retained and reinvested in its business.  "Earned Surplus" has, it is true,  not  been  called "reserve", but if  it  is  truly  a reserve, it must be taken into account in the computation of capital.   In considering this question, it is necessary  to note  certain special features of the system  of  accounting obtaining  in the United States of America.  In the  balance sheet%   of  companies  the  assets  are  balanced   against liabilities,  capital  stock and surplus.   In  the  company accounts  it  is usual to provide for  specific  or  special reserves,  but  there  is no allocation  to  a  head  called "General reserve" in the accounts.  It is also well  settled that the accounts of companies maintained under the American system  are self-contained for each year.  Under the  system of accounting in vogue in India, after allocations are  made to various purposes such as outgoing, expenses and reserves, specific  and  general  the  balance  is  generally  carried forward  to  the next year.  The amount so  carried  forward gets  merged  into  the account of the next  year.   If  the capital and liabilities side exceeds the property and assets side, the difference is carried forward as loss in the  next year.   Under  the American system of  accounting,  whatever remains  on  hand at the end of the year is entered  on  the liabilities, capital stock and surplus side as "Earned 3 79 Surplus".   This  was pointed out in First  National.   City Bank v. Commissioner of Income-tax, Bombay(1), where  Kapur, speaking for the Court observed :               "There  is a difference between the system  of               accounting  of banking companies in India  and               the  United States : . . . . In India  at  the               end  of  a  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

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             year.   In  the system of  accounting  in  the               U.S.A.  each year’s account is  self-contained               and  nothing  is carried  forward.   If  after               allocating   the  profits  to  diverse   heads               mentioned  above  any balance remains,  it  is               carried  to  the  "Undivided  Profits"   which               ’become  part of the capital fund.  If in  any               year as a result of the allocation there is  a               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  every   nature   the               Undivided Profits are accumulation of  amounts               of  residue  on  hand at the end  of  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." 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 accounts of a banking company : they are applicable  with appropriate variations to accounts  of  all companies,  and  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 a 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 reserves". The Appellate Tribunal held that the "Earned Surplus" in the balance   sheets   of  the  assessee   company   represented "reserves"  within  the  meaning  of r. 2  Sch.  11  of  the Business  Profits Tax Act.  The High Court agreed with  that view.    But   counsel  for  the  Revenue   contended   that accumulated profits could only be (1)  [1961] 3 S.C.R. 371. 380 deemed reserves for the purpose of the Business Profits  Tax Act, if they are specifically allocated to reserves and  not otherwise and in support of that contention, he relied  upon the  decision  of  this  Court in  the  Century  Spinning  & Manufacturing  Company Ltd.(1) Counsel pointed out  that  in that case this Court reversed the decision of the High Court of  Bombay  in which accumulated profits  were  regarded  as reserves  for the purpose of the Business Profits  Tax  Act. It  is  necessary carefully to scrutinise the facts  in  the Century  Spg.  & Mfg.  Company’s case(1).  For  the  account year  ending December 31, 1945, the profit of  the  assessee company,  amounted to Rs. 90,44,677/-.  After providing  for depreciation  and  taxation there  remained  an  unallocated balance of Rs. 5,08,637/- which was not allowed in computing the  profits of the assessee for purpose of income-tax.   In February  1946, the directors recommended that out  of  that amount  a sum of Rs. 4,92,426/- be distributed  as  dividend and the balance of Rs. 16,21 1 /- be carried forward to  the next year’s account.  The recommendation was accepted by the shareholders    and   dividend   was   shortly    thereafter distributed.   In  computing  the capital  of  the  assessee company on April 1, 1946 under the Business Profits Tax Act, 1947,  the  assessee  claimed that  Rs.  5,08,637/-  carried forward  into  the  account of 1946  should  be  treated  as

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"reserve"  for the purpose of r. 2 ( 1 ) of Sch.  11.   This Court negatived the contention.  Ghulam Hasan, J.,  speaking for the Court observed               "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  January,               1946, cannot automatically make it a  reserve.               On   the  1st  April,  1946,  which   is   the               commencement  of  the  chargeable   accounting               period,  there was merely a recommendation  by               the  directors  that the  amount  in  question               should  be distributed as dividend.  Far  from               showing that the directors had made the amount               in question, a reserve, it shows that they hid               decided  to  ear-mark it for  distribution  as               dividend." After  referring  to  the judgment of the  High  Court,  the learned Judge observed : (1)  [1954] S.C.R. 203.                             381               "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               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 unutilized and not specially set               apart for any purpose on the crucial date  did               not constitute reserves within the meaning  of               Schedule 11, rule 2(1)." It  was  pointed out that under the  Indian  Companies  Act, 1913, the directors are enjoined to attach to every  balance sheet  a report with respect to the state of  the  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.  It was also pointed out that S. 132 of the Indian  Companies Act refers to the contents of the  balance sheet to be drawn up in the Form marked ’F’ in Sch.  HI, and to Regulation 99 of the 1st Sch.  Table A, and observed that any  sum  out of the profits which is to be carried  into  a reserve must be set aside before the directors recommend any dividend.  The Court observed:               "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

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             also support the conclusion as to what is  the               true  nature of a reserve shown in  a  balance               sheet." The  Court was dealing in that case with the accounts of  an Indian  Company,  the balance sheet of  which  was  prepared according  to  the provisions of the Indian  Companies  Act, 1913.  Regulation 99 of the 1st Sch.  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.   ’Me identity of the amount remaining on hand at the foot of  the profit & loss account was not preserved. 382 It  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. 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 : some may  be specific 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  reserve  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.  The accumulated profits  of the  assessee company according to the system of  accounting at  the  end of the year were not carried forward  into  the account of the next year as they could not be, according  to the  system  of accounting prevalent in the  United  States. They  had  to be allocated to some account,  and  they  were allocated  to "Earned Surplus", which was intended  for  and was  used  in  subsequent  years for  the  purposes  of  the business of the assessee company.  The account in which this amount  was carried retained its identity year  after  year. In  the First National City Bank’s case(1), this Court  held that  the  undivided  profits brought into  account  of  the assessee Bank under the head "Assets, capital, capital stock and reserves" were reserves within the meaning of r. 2(1) of Sch.  II of the Business Profits Tax Act.  In that case  the Court was dealing with a case of a banking institution,  and a letter from the Deputy Controller of Currency, Washington, was tendered in evidence which explained that in the  United States   the  "Undivided  Profits"  as  reflected   in   the accounting  of  a  bank actually represent  a  part  of  its capital funds, and that the term "Undivided Profits"  simply followed  a bank accounting nomenclature used  to  designate profits  set aside after provisions for expenses and  taxes, dividends  and  reserves, for continuous future use  in  the business of the Bank. (1)  [1961] 3 S.C.R. 371.                             383 In the case before us we have no such evidence on the record about  the nature of the "Earned Surplus" account,  but  the manner  in  Which  the balance sheets year  after  year  are maintained, and the general accountancy practice  prevailing

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in  the  United  States,  suggest  that  there  is  specific allocation  of  the balance of profits ,at the end  of  each accounting year. The  following  table prepared from the balance  sheets  and filed  on  behalf of the assessee company,  (correctness  of which has been accepted), clearly supports that view. --------------------------------------------------------- Earnings               Appro-     Earnings        Fixed Year Reinvested Net    priations   Reinvested      Assets Earned         Profit  (made       (Earned    (at cost) surplus)               within      Surplus) Opening                 year)       Closing Balance                             Balance -----------------------------------------------------------           $      $              $              $ ----------------------------------------------------------- 945  16299765  13257841--295575977654167 1946 29557597  243553701000000043912958    82534231 1947 43912968  228618371000000056774805    110767579 1948 56774805  369917872000000073766592    19672)177 1849 73766592  388825892000000092649181    2)7045227 ------------------------------------------------------------- The Table disclosed that the balance of "Earned Surplus"  at the  end of the year did not merge into the account  of  the subsequent  year.   It represented a specific  account  into which   were  added  the  net  profits  of  the   year   and appropriations  were  made  out of it and  the  balance  was regarded  as "Earned Surplus" at the end of the year.   This account  was specifically allocated for utilisation for  the purpose  of business year after year.  It was an account  in which  the net profits less the appropriations  were  added, and  the account was intended for application  in  extending the  business of the assessee company.  The amounts  entered in the account ’Earned Surplus" cannot therefore be regarded as  mere  unallocated profits at the end of  the  accounting year. The  High  Court  was therefore right in  holding  that  the "Earned Surplus" represented reserves.  The method in  which the accounts are maintained in the light of the  accountancy practice  clearly  indicates that at the end of  each  year, there have been specific appropriations in the account,  and the conditions which this Court regarded as essential in the Century  Spinning  &  Manufacturing  Company’s  case(1)  for constituting the fund into reserve are fulfilled. The  appeals fail and must be dismissed with  costs.   There will be one hearing fee. Appeals dismissed. (1) [1954] S.C.R. 203. 2SUP.C.I./6611 384