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PETITIONER: THE FIRST NATIONAL CITY BANK

       Vs.

RESPONDENT: THE COMMISSIONER OF INCOME-TAX,BOMBAY CITY.

DATE OF JUDGMENT: 06/01/1961

BENCH: KAPUR, J.L. BENCH: KAPUR, J.L. HIDAYATULLAH, M. SHAH, J.C.

CITATION:  1961 AIR  812            1961 SCR  (3) 371  CITATOR INFO :  RF         1966 SC1393  (16,20)  RF         1981 SC2105  (27)

ACT: Business  Profits Tax--" Undivided profits", if fell  within the word "reserves"--Business Profits Tax Act, 1947 (XXI  of 1947), Sch. 11, Rule 2(1).

HEADNOTE: The appellant, a non-resident Banker incorporated under  the National  Bank Act of the United States of America with  its Head Office in America, was assessed under Business  Profits Tax Act, 147.  Under the Treasury Rules of the United States of  America and Instructions for preparation of  reports  of conditions by the National Banking Association certain  sums had  to  be  specifically allocated under  S.  5211  of  the Revised Statute of the United States, and the appellant bank was required to keep a certain sum of money under the head " undivided  profits " and that was an integral part  of  tile capital  structure.   The reason for the existence  of  this fund was that when losses occurred according to the practice they  could be charged against " undivided profits ",  i.e., profits  set  apart after provision for expenses  and  taxes etc.  for continuous use in the business of the  Bank.   The appellant  contended  that in computing the amount  for  the purpose  of  " abatement " it was entitled  to  include  the undivided profits " which fell within the word " reserves ". The  question was whether the large sum of money shown as  " undivided profits " was a part of the reserves. Held, that the amount designated as " undivided profits  was a part of the reserves and had to be taken into account when computing the capital and reserves within Rule 2(1) of  Sch. II of the Business Profits Tax Act, 1947.

JUDGMENT: CIVIL  APPELLATE JURISDICTION: Civil Appeal No. 315/1958. Appeal  by special leave from the judgment and  order  dated February  5,  1957, of the Bombay High Court in  I.T.R.  No. 34/1956.

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372 R.   J. Kolah, and I. N. Shorff, for the appellant. A.   N. Kripal and D. Gupta, for the respondent. 1961.  January 6. The Judgment of the court was delivered by KAPUR, J.-This is ail appeal against the judgment and  order of  the  High Court of Judicature at  Bombay  in  Income-tax Reference  No. 34 of 1956.  The appellant is a  non-resident Bank incorporated under the National Bank Act of the  United States  of America with its head office in that country  and with branches all over the world including some branches  in India.   It was assessed under the Business Profits Tax  Act (Act  XXI  of  1947), hereinafter termed the  "  Act  ",  in respect of the chargeable accounting periods:- 1-4-1946 to 24-12-1946, 25-12-1946 to 24-12-1947, 25-12-1947 to 23-12-1948, and 24-12-1948 to 31-3-1949 and  the  sole question for decision in this appeal  is  the meaning of the word " reserves " in R. 2(1) of Schedule 2 of the  Act  and how the capital of the  appellant  during  the above-mentioned  chargeable  accounting periods  has  to  be computed for the purpose of allowing the " abatement " under the Act. The appellant contended that in computing the amount for the purpose  of  abatement it was entitled to  include  what  is termed  in  the  United States " Undivided  Profits  ",  the contention  being  that this item falls within  the  word  " reserves"  in  R.  2(1)  of Schedule 11  of  the  Act  which provides:               "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 purpose 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." 373 It  is not necessary to give the details of all  the  years; but it will be sufficient as an illustration if we: were  to confine  ourselves  to  the " Undivided  Profits  "  in  the Balance Sheet as on December 31, 1946, wherein the  relevant entries were as follows : Capital ...  ...    $ 77,500,000-00 Surplus ...  ...    $ 152,500,000.00 Undivided Profit ...$ 29,534,614.21 The  Report of the Directors dated January 14, 1947, was  as follows:               " At the year-end, Capital of the Bank remains               at  $  77,500,000 surplus has increased  to  $               152,500,000 by the transfer of Rs.  10,000,000               from Undivided Profits.  After this  transfer,               Undivided Profits are $ 29,534,614 an increase               of  $  240,376  from a year  ago.   The  Trust               Company has Capital of $ 10,000,000 surplus of               s  10,000,000  and  Undivided  Profits  of   $               8,097,020.   The  two institutions  thus  show               total capital funds, that is Capital,  Surplus               and  Undivided Profits of $ 287,631,634  or  $               46-39  per  share compared with  $  44.60  per               share at the end of 1945.  " According to the Balance Sheet of 1948, capital funds  since

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1939  had  increased from $ 169,768 thousands to  $  320,795 thousands in the year 1948 and there had been a  progressive increase  both  in what is called " Surplus " as well  as  " Undivided  Profits  ", the former increased  from  $  62,500 thousands  to  $  182,500 thousands and the  latter  from  $ 19,768  thousands  to $ 50,795 thousands.  The  question  in this  case  is whether this large sum of money  shown  as  " Undivided  Profits  "  is  a part  of  the  Reserves  or  is equivalent to the unallocated amount carried forward at  the end  of  a year of account in the balance of Profit  &  Loss Account  as we know it.  It was the sum of  $  29,534,614.21 and similar sums for the other chargeable Accounting Periods which are the subject matter of controversy in this  appeal. Both  the  Income-tax Officer and  the  Appellate  Assistant Commissioner  excluded  these  amounts  in  determining  the capital  of  the Bank under R. 2(1) of Schedule  II  on  the ground  that  they were not a part of the reserves  of  the- Bank. 374 The  appellant  took an appeal to the  Income-tax  Appellate Tribunal which was dismissed on the ground that "  Undivided Profits  "  meant  nothing more than the "  Balance  of  the profits  and loss account" and that no distinction could  be drawn merely because in the nomenclature used in the  United States, the amount was shown as " Undivided Profits" and not balance of the profit and loss account.  At the instance  of the appellant the following question of law was referred  to the High Court.               "   Whether   on   the  facts   and   in   the               circumstances of the case I Undivided Profits’               of  $  29,534,614.21 shown  in  the  condensed               statements  of conditions as of  December  31,               1946, can be treated as reserves and added  to               the  capital,  as  required by  rule  2(1)  of               Schedule  II to the Business Profits  Tax  Act               for  the chargeable accounting  period  25-12-               1946 to 24-12-1947?" In  its order the Tribunal said that the Treasury  Rules  in United  States divided capital account into  four  different heads, Capital, Reserve, Surplus and the Undivided  Profits. The  reserves are really reserves for liabilities  including the reserves for dividends.  " The general reserves as shown by the balance sheet in India is equivalent to the  Surplus. The undivided profits is equivalent to the balance of profit and loss account." In the statement of the Case submitted to the  High  Court,  the Appellate Tribunal  stated  that  the question whether the Undivided Profits meant the same  thing as balance of the profit and loss account was a question  of fact  and it did not matter what name was given to it.   But this  was the very question which was referred to  the  High Court. The  High Court after referring to the Directors’ Report  to the  shareholders  held  that  the  Undivided  Profit  of  $ 29,534,614.21  did  not constitute " reserves "  because  no direction had been given in regard to it, it had never  been transferred to any reserve and had never been earmarked  for any particular purpose and that the only act of volition  on the part of the Directors of the Bank was the transfer of 10 million 375 dollars to the Surplus.  In its judgment the High Court said :               "It  is true that these large amounts (of  Un-               divided  Profits) remain with the  Bank,  that               the  Bank uses them, that business is  carried

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             on with the help of those funds and that  they               are as much capital of the Bank as capital  in               the strict sense of the term.  " The  High Court however held that they did not  satisfy  the test  laid down by the Supreme Court in Century  Spinning  & Manufacturing  Co. Ltd. v. C.I.T., Bombay (1) as the  amount was not transferred to any reserve and there being no act of volition  on  the part of the Directors this  could  not  be regarded  as  Reserve.   The correctness  of  this  view  is challenged before us. The Directors’ report dated January 14, 1947, shows that the surplus increased as a result of the allocation made by  the Directors,  by  10  million Dollars, which  was  taken  from Undivided  Profits  and  the  Undivided  Profits  themselves increased  to  $29,534,614.21  which  was  an  increase   of $240,376 in the year 1946 and therefore the Capital Funds of the  company which included Capital, Surplus  and  Undivided Profits along with similar items from the Trust Company  had increased  considerably  which was reflected  in  per  share increase, i.e., 44.60 per share at the end of 1945 to  46.39 per  share at the end of 1946 thus showing that it  was  the result of an act of the Directors that Surplus was increased and a particular sum was left in the Undivided Profits. It was contended that no sum could be treated as  ’Reserves’ unless  the Directors recommended it to be so allocated  and it  was so adopted by the shareholders.  But  this  argument ignores  the  evidence placed by the appellant.   Under  the Treasury Rules of the United States of America containing  " Instructions  for  Preparation of Reports  of  Condition  by National  Banking  Associations ", certain sums  had  to  be specifically allocated under s. 5211 of the revised  Statute of the United States (Title 12, U. S. C. 161).  Items 25  to 28, according to these instructions, deal (1)  [1954] S.C.R. 203. 376 with Capital Account.  Item 26 deals with ’Surplus’ and item 27  with ’Undivided Profits’ and item 28 with ’  Reserves  ’ (and retirement account for preferred stock).  The following Reserves come under item 28:- (a)..Reserve for dividends payable in Common stock. (b)  Reserves for other undeclared dividends. (c)  Retirement account for,preferred stock. (d)  Reserves for contingencies, etc. Item 29 was as follows " Total capital accounts ". This item is the sum of items 25 to 28, inclusive. Along  with  this  the appellant has placed a  copy  of  the letter  from the Deputy Controller of Currency,  Washington, the relevant portion of which is as follows :-               "  In connection with this matter we  wish  to               assure you that your position as stated is  in               complete accord with that of the Office of the               Comptroller  of the Currency.  In  the  United               States,  the ’Undivided Profits’ as  reflected               in   the   accounting  of  a   bank   actually               represents  a part of its capital funds.   All               of the other bank supervisory agencies in  the               United States consider the ’Undivided Profits’               of a bank as a part of its capital funds.   In               any calculation for the purpose of determining               the adequacy of capital in a: commercial  bank               in   the   United  States,   the   supervisory               authorities include ’Undivided Profits’ as  an               integral  part of the capital structure as  it               would  not  be possible otherwise to  make  an

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             accurate  computation.  When losses  occur  in               banks, it is the usual practice in many  banks               to charge them against the ’Undivided Profits’               account  which  by  any  reasoning  would   be               inappropriate if the account were regarded  as               ’ Undistributed Profits’.  In commercial banks               in  the United States, it is not customary  to               maintain  any account that could  be  regarded               specifically as ’Undistributed Profits’ in the               same. sense as applied to similar accounts  in               the  other  corporations in India.   The  term               ’Undivided  Profits’  simply  follows  a  bank               accounting  nomenclature used ill the  ’United               States to               377               designate profits set aside, after  provisions               for   expenses   and  taxes,   dividends   and               reserves,  for  continuous future use  in  the               business of the bank’ and it bears a close, if               not  identical,  relationship  to  the  Earned               Surplus Account of an industrial corporation. Balance  sheets  of three other banks of the  United  States relied on by the appellant show that Capital Fund  comprises three  kinds of funds, i.e., Capital, Surplus and  Undivided Profits.  The documents placed on the record show that these three different kinds of funds put together make up what  is called " Capital Fund’.  The creation and maintenance of the item  known  as Undivided Profits is a  requirement  of  the Treasury  Rules  which  are  made  under  the  Statute   and therefore  it  cannot be said that the amount  of  Undivided Profits  in the Balance Sheet was not allocated as a  result of  either  a resolution of the Directors, accepted  by  the shareholders  or on account of the requirements of the  law. The " Undivided Profits " have to be employed in the  manner indicated  by  the  letter  of  the  Deputy  Controller   of Currency.   They are set up for expenses,  taxes,  dividends and reserves for continuous use in the business of the  Bank and are a part of the capital funds and an integral part  of the  capital  structure  and without it,  it  would  not  be possible  to make an accurate computation.  The  reason  for the existence of this fund, as shown by that letter is  that when there are losses, they can be charged against "Undivid- ed Profits " which expression means profits set apart  after provision for expenses and taxes etc. for continuous use  in the business of the Bank. There  is a difference between the system of  accounting  of Banking  Companies  in  India and  the  United  States;  the failure to appreciate this difference has led the  Appellate Tribunal as well as the High Court to arrive at an erroneous conclusion.   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 48 378 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 credited  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  very nature the Undivided Profits are  accumulation  of amounts of residue on hand at the end of year of  successive

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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. The  nature  of " Undivided Profits" was considered  by  the Supreme Court of America in Fidelity Title and Trust Co.  v. United  States (1).  In that case a suit was brought by  the Fedelity  Co.  to  recover the tax  assessed  on  its  whole capital and undivided profits under s. 2 of the Spanish  War Revenue  Act.  In the Supreme Court it was contended by  the company  that  the  terms  "Capital",  "  Surplus  "  and  " Undivided  Profits " have a precise and definite meaning  in the  business of banking and that Undivided Profits are  not surplus  and cannot therefore be taxed as " Surplus  ".  The Government  on the other hand contended that  the  undivided profits were taxable as being a part of Capital or  Surplus. The  Court held that " Undivided Profits ". were taxable  as being a part of the Capital employed.  Mr. Justice  Brandeis delivering the opinion of the Court said at p. 955:               " The Act declares that ’in estimating capital               surplus  shall  be  included,’  and  that  the               ’annual tax shall in all cases be computed  on               the  basis of the capital and surplus for  the               preceding                              fisical               year.........................................."               As  it is the use or employment of capital  in               banking,  not mere possession thereof  by  the               banker,  which determines the amount  of  tax,               the fact that a portion of the capital so used               or employed is (1)  66 L. Ed. 953 ; (1921) 259 U.S. 304 379 designated   ’undivided  profits’  is  of  no  legal  signi- ficance." As  to  what the word " Reserves " as used in  the  Business Profits  Tax Act connotes, was considered by this  Court  in the  Commissioner  of  Income-tax  v.  Century  Spinning   & Manufacturing  Co.  Ltd.  (1).  It was held  that  the  true nature and character of a sum disputed as reserve was to  be determined  with reference to the substance of  the  matter. The amount in dispute in that case was the profits after the deduction  of depreciation and tax which amount was  carried to  the  Balance  Sheet and was  later  recommended  by  the Directors to be appropriated mainly to dividends and balance to  be carried forward to the next year’s account.  Thus  on the  crucial  date,  i.e., April 1,  1946,  from  which  the Chargeable  Accounting Period began the sum in  dispute  had not  been  declared  as  reserve;  on  the  other  hand  the Directors had earmarked it for distribution as dividend  and it remained as a mass of undistributed profits available for distribution.  At page 209 Ghulam Hassan J. said:-               "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 .........................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...................."

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Applying  this test to the disputed sum, it cannot  be  said that  the amount is not "Reserve" within the meaning of  the Rules.  As is shown by the instruction under s. 5211 of  the Revised  Statute of the United States and the letter of  the Deputy Controller referred to above, the appellant bank  was required  to keep a, certain sum of money under the  head  " Undivided  ,Profits  " and that is an integral part  of  the capital (1)  [1954] S.C.R. 203. 380 structure.  Under these circumstances it would be  erroneous not  to treat the amount of " Undivided Profits " as a  part of the capital fund. In our opinion therefore the amount designated as  Undivided Profits " is a part of the reserves and has to be taken into account  when computing the capital and reserves  within  R. 2(1)  of  Schedule 11 of the Act.  The  question  which  was referred  by  the Tribunal should have been decided  in  the affirmative  and in favour of the appellant and  the  amount should have been added to the capital as allowed by R.  2(1) for  the Chargeable Accounting Periods.  In the  result  the appeal  is  allowed.  The appellant will have its  costs  in this Court and in the High Court.                                  Appeal allowed.                  _________________