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PETITIONER: NATIONAL RAYON CORPORATION LTD.

       Vs.

RESPONDENT: THE COMMISSIONER OF INCOME TAX

DATE OF JUDGMENT:       29/07/1997

BENCH: SUHAS C. SEN, K. T. THOMAS

ACT:

HEADNOTE:

JUDGMENT:             (WITH C.A NOS. 2/95, 198/89, 432/89,                     433/89 AND 2970/81)                       J U D G M E N T SEN, J.      The point  that falls for determination in this case is whether  a  sum  of  Rs.  79  lakhs  representing  Debenture Redemption Reserve  was includible  in computing the capital of  the  assessee  Company  for  the  purpose  of  Companies (Profits) Surtax Act, 1964.      The High  Court took the view that the amount set apart to redeem  the debentures  has to  be treated as ’provision’ and not as ’reserve’.  The facts stated by the High Court in this regard are as follows:      "From the  balance-sheets  for  the      said periods,  we find  that in the      calendar year 1965, the development      rebate reserve  was Rs.  79,00,000.      However, in  the next calendar year      1966,  which  is  relevant  to  the      assessment year 1967-68, the figure      of debenture redemption reserve has      gone up  to  Rs.  1,12,00,000.    A      perusal   of    the   balance-sheet      further  shows  that  the  assessee      company  had  floated  an  actually      issued  6   1/2  per  cent  secured      redeemable mortgage  debentures, as      pointed out  earlier,  against  the      security  of  land,  buildings  and      machinery  of  the  company  and  a      floating charge on the undertaking.      None of  these debentures appear to      have  been   redeemed  during   the      relevant previous  years.  There is      no dispute  regarding any  of these      facts.   In these circumstances, it      clearly  appears  to  us  that  the      debenture redemption  reserve  must      be regarded  as a provision made by      the assessee  company to  enable it

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    to redeem  the said debentures when      they  became  due  for  redemption.      Since the  aggregate amount  o such      debentures is  much larger than the      amount of  the debenture redemption      reserve, we  fail to see how it can      be said  that there  was any excess      as such in this appropriation which      could be  taken as  reserve.  It is      true that  all the  debentures  had      not become  redeemable  during  the      relevant previous  years, but  that      does  not   make   any   difference      because an amount set aside to meet      a  future   liability,  which   was      certain to  come into existence, as      in this case, must be regarded as a      provision and not as a reserve."      We are  of the  view that  the High Court has come to a correct conclusion.   The  basic principle is that an amount set apart  to meet  a known  liability cannot be regarded as ’Reserve’. ’Provision’  and ’Reserve’  have been  defined in Part III, Schedule VI of the Companies Act itself:      "7. (1)  For the purposes of Part I      and II of this Schedule, unless the      context otherwise requires,-      (a)  the   expression   "provision"      shall, subject to sub-clause (2) of      this  Clause,   mean   any   amount      written off  or retained  by way of      providing     for     depreciation,      renewals or  diminution in value of      assets,  or   retained  by  way  of      providing for  any known  liability      of  which   the  amount  cannot  be      determined     with     substantial      accuracy:      (b) the  expression "reserve" shall      not, subject  as aforesaid, include      any amount  written off or retained      by    way    of    providing    for      depreciation,      renewals      or      diminution in  value of  assets  or      retained by  way of  providing  for      any known liability;      (c)   the    expression    "capital      reserve"  shall   not  include  any      amount   regarded   as   free   for      distribution through the profit and      loss account;  and  the  expression      revenue  reserve   shall  mean  any      reserve  other   than   a   capital      reserve; and in  this sub-clause  the  expression  "liability"  shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities. (2) Where-      (a)  any   amount  written  off  or      retained by  way of  providing  for      depreciation,      renewals      or      diminution in  value of assets, not      being  an  amount  written  off  in      relation to fixed assets before the      commencement of this Act; or      (b) any  amount retained  by way of

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    providing for  any known liability;      is in excess of the amount which in      the opinion  of  the  directors  is      reasonably   necessary    for   the      purpose,  the   excess   shall   be      treated for  the purposes  of  this      Schedule as  a reserve and not as a      provision.      The definition  clearly indicates  that if an amount is retained by  way of  providing for  any known liability that amount shall  not be  treated as  reserve.   Clause  7(2)(b) makes it  clear that  only an  amount which  is in excess of what is  reasonably necessary  for meeting a known liability shall be  treated as  reserve and  not as  provision.    The directors will  have to  form  an  opinion  as  to  what  is reasonably necessary  for meeting  the known  liability of a Company.   The opinion  of an  accountant or an auditor or a lawyer is quite immaterial for this purpose.      The finding of fact in this case is that the amount set apart  for   redemption  of  debentures  is  less  than  the Company’s liability  on this account.  Therefore, the answer to the  question raised  must be  that the  amount of Rs. 79 lakhs representing  Debenture Redemption  Reserve cannot  be included in  the capital  of the  Company for the purpose of Surtax assessment.   The facts stated in the judgment of the High Court  go to  show that  the amount was not larger than the amount  which had  to be  paid  for  redemption  of  the debentures.   Therefore, there  is no question of any excess provision in this case.      In the  case  of  Vazir  Sultan  Tobacco  Co.  Ltd.  V. Commissioner of  Income Tax,  A.P., 132  I.T.R. 559,  it was held that  ’provision’ and  ’reserve’ had  not been  defined under the  Companies (profits) Surtax Act, 1964.  Therefore, the two  concepts ’reserve’ and ’provision’ which are fairly well known  in commercial  accountancy and  which  are  used under the  Companies Act dealing with preparation of Balance Sheets and  Profit  and  Loss  Accounts,  will  have  to  be gathered from  the meaning attached to them by the Companies Act itself.   Moreover,  in  Vazir  Sultan’s  Case,  it  was pointed out  that even  if a sum of money which had been set apart  for   a  certain   purpose  was  held  not  to  be  a ’provision’, it  did not automatically follows that it would be a reserve.  It was held:      "But it  is clear beyond doubt that      if any  retention or  appropriation      of a  sum is  not a provision, that      is to  say, if it is not designated      to meet  depreciation, renewals  or      diminution in  value of  assets  or      any known  liability, the  same  is      not necessarily  a reserve.   We re      emphasising  this   aspect  of  the      matter because  during the  hearing      almost   all    counsel   for   the      assessees   strenuously   contended      before us that once it was shown or      became clear  that the retention or      appropriation  of   a  sum  out  of      profits  and  surplus  was  for  an      unknown   liability    or   for   a      liability which  did not  exist  on      the  relevant   date,  it  must  be      regarded as a reserve.  The fallacy      underlying the  contention  becomes      apparent if  the negative  and non-

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    exhaustive    aspects     of    the      definition of  reserve are borne in      mind."      It has  been contended  by Shri  T.A.  Ramachandran  on behalf of  the assessee  that what  is set apart for meeting the current  year’s known  or estimated  liability  will  be ’provision’.  An amount set apart for future use will not be ’provision’.   This argument  is without any merit.  It goes against the  very definition  of ’provision’  and  ’reserve’ provided by the Companies Act.  in the form of Balance Sheet in Schedule  VI of  the Companies  Act provisions have to be made, inter  alia. for Contingencies, Provident Fund Scheme, insurance, Pension  and Staff  benefit schemes.  Amounts set apart for  the aforesaid  purposes will mostly be for future use.   Question of  payment of pension or provident fund can only arise when an employee retires.      Mr. Ramachandran  advanced another  argument that there was no present liability to pay any amount to the debenture- holders.   That liability  will arise  only when  the amount falls due  for payment.   Therefore,  there was  no existing liability for  redeeming the debentures in the relevant year of account.      We are  unable to  uphold this argument.  The liability to repay  arises the  moment the  money is  borrowed.    The amount borrowed  may be  repayable immediately or in future. The date  of repayment  of loan may be deferred by agreement but the  obligation or the liability to repay will not cease on that  account.   The obligation  is a present obligation; Debitum in  Praesenti, solvendum  in futuro.  This aspect of the matter  was explained  in the  judgment of this Court in Kesoram  Industries   and  Cotton   Mills   Ltd.,   v.   The Commissioner of  Wealth Tax (Central), Calcutta, A.I.R. 1996 SC 1370.      By issuing the debentures, the company had taken a loan against the  security of  its assets.   This loan may not be repayable in the year of account.  But the obligation to pay the loan  is a  present obligation.   Any money set apart in the accounts of the company to redeem the debentures must be treated as  moneys set apart to meet a known liability.  The debentures will  have to  be shown  in the Company’s Balance Sheet of the year as ’Liability’.      In the  case of  Commissioner of  Income Tax  vs. Peico Electronics 7  Electricals. 166  ITR 299,  the Calcutta High Court held  that the  debenture redemption reserve will have to be  treated asa  ’reserve’ and  not ’provision’  because, none  of   the  debentures   became  redeemable  during  the accounting period.   The  liability to redeem the debentures was a  future liability.  The debentures had been separately shown in  the balance sheet as a liability.  The reserve had been created by appropriation of profits and not by way of a charge on revenue.      We are  of the view that this approach is erroneous and overlooks the definitions of ’provision’ and ’reserve’ given ion the  Companies Act.   The  debentures were  nothing  but secured loans.   Merely  because, the  debentures  were  not redeemable during  the accounting  period, the  liability to redeem the  debentures did  not cease  to  exist.    It  was redeemable or  repayable at  a future  date.   But is  was a known liability.  In the form of balance sheet prescribed by the Act  in Schedule  VI, the secured loans have to be shown under the  heading ’liabilities’.   Secured loans have to be shown  under  the  heading  ’liabilities’.    Secured  loans include (1)  debentures, (2)  loans and advances from banks. (3) loans and advances from subsidiaries and (4) other loans and advances.   The  secured loans  might not be immediately

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repayable, but  the liability  to repay  these loans  was an existing liability  and has  to be  shown in  the  Company’s Balance  Sheet  for  the  relevant  year  of  account  as  a liability.   Amount set  apart to  pay these loans cannot be ’reserve’.   The interpretation  clause of the Balance Sheet in Schedule  VI of  the Companies Act specifically lays down that reserves  shall not  include  any  amount  written  off retained by way of providing for a known liability.      The Delhi  High Court  in the  case of  Commissioner of Income Tax  v. Modi Industries Ltd. (No.2), 197 ITR 655 also took the  view that  the amount  set apart out of profits to redeem the debentures had to be treated as reserves because, there was  no liability  in the  current year  to redeem the debentures.      We are  unable to  agree with this view for the reasons given earlier in the judgment.      Apart from  this, the  argument that  found favour with the Courts  in the  cases of Peico Electronics & Electricals and Modi  Industries Ltd.  (supra) that  if the retention or appropriation of  a sum  of profits and surpluses was for an unknown liability  of for a liability which did not exist on the relevant  date it  must be  regarded as a ’reserve’, was specifically rejected  by this  Court in Vazir Sultan’s Case (supra).   This argument  of the  assessee was  held  to  be fallacious (Page 571 of the  report).      There  is   another  aspect  of  this  case.    In  the prescribed  form   of  Balance   Sheet,  under  the  heading "RESERVES AND  SURPLUSES" seven types of reserves have to be shown:      (1) Capital Reserves,      (2) Capital Redemption Reserve,      (3) Share Premium Account      (4) Other reserves,      (5) Surplus, i.e., balance in profit and loss account.      (6) Proposed additions to reserves.      (7) Sinking funds.      However, for the purpose of computation of capital of a company under  the Companies  (Profits)  Surtax  Act,  1964, items 5,6  and 7 will not be treated as Reserves. The Second Schedule  of   the  Surtax  Act  lays  down  the  rules  for computation of  the capital.  Rule 1 contains an Explanation to the following effect:      "Explanation, -  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  1st 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 OF BALANCE - SHEET’ given      in Part  I of  Schedule VI  to  the      Companies Act,  1956 (1  of  1956),      shall not  be regarded as a reserve      for the  purposes of computation of      the capital  of a company under the      provisions of this Schedule."      In Batliboi’s  advanced Accountancy,  27th Edn.  p.678, the nature of a Sinking Funds is explained as under;      "Sinking Fund.  - A Sinking Fund is

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    a fund  created with  the object of      providing means  for the redemption      of liabilities  like debentures  or      any other  loan.   It is  formed by      setting  aside,   half  yearly   or      yearly, a  fixed sum of money for a      definite period,  such  sum  to  be      invested at  compound interest,  so      that at  the end of the period, the      annual amounts,  with accumulations      of interest,  will be sufficient to      discharge a  prescribed loan.    In      such a  case, the  amount set aside      should not  be debited  to  Revenue      Account  but   to  a   Net  Revenue      Account   or    Profit   and   Loss      Appropriation  Account,   as  being      rather  in   the   nature   of   an      allocation of profits than a charge      against them."      A Sinking  Fund created  for redemption  of  debentures will not  be treated as Reserve even though (1) it has to be shown as  "Reserve" in  the Balance Sheet and (2) the amount kept in  this fund is in the nature of allocation of profits and not  a charge  against them.  It is difficult to see, in the context  of this  rule in  the Second  Schedule,  why  a Debenture Redemption  Reserve is  to be treated as "Reserve" on the  ground that  the amounts set apart for redemption of debentures are not in the nature of a charge against profits but merely  appropriation of profit.  In Peico Electronics & Electricals Case  (supra), one  of the grounds which weighed with the Court was the argument that the Sinking Fund has to be utilised  by making  investments and did not form part of the working  capital of  the Company but the amount lying to the credit  of Debenture Redemption Reserve was available to the Company to used as working capital.      We fail  to comphrehend  this distinction.  what has to be computed  under Rule  1 of  the Second  Schedule  of  the Surtax Act is the capital of the Company and not its working capital.   The amount shown as Sinking Funds may be invested in a  fruitful way  so that the principal and gains from the investments taken  together will  enable the  Company to pay off its  debts.  Investment of monies standing to the credit of the  Sinking Fund  is  nothing  but  utilisation  of  the Company’s assets  for  the  discharge  of  its  liabilities. There is  no rational  explanation why  a Sinking  Fund  for redemption of  debentures  will  not  be  a  reserve  but  a Debenture Redemption  Reserve created  with the same purpose will be  treated as  reserve and  included in computation of capital of  the Company for surtax purposes.  A construction which leads to absurdity should be avoided.      The basic  principle is that any amount retained by way of providing  for a  known liability  will not be ’reserve’. Explanation to  Rule 1  of the Second Schedule of the Surtax Act takes  this  principle  to  its  logical  conclusion  by providing that even a Sinking Fund, which has to be shown as a reserve  in the prescribed form of balance Sheet, will not be treated  as ’Reserve’  for the  purpose of computation of capital.      It  is  further  to  be  noted  that  the  surplus  and unallocated balance  in the Profit and Loss Account has been specifically excluded  from "reserves"  for  computation  of capital under  the Surtax  Act.   Therefore, availability of the amount for utilisation as working capital of the Company or for  distribution of  dividend cannot  be a criterion for

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deciding whether  a  particular  amount  retained  from  the profits of  the Company  will be  treated as  its reserve or not.      In the  premises, we  are of the view that the judgment under appeal;  was rightly decided.  We are unable to uphold the contrary  decisions in  the cases of Peico Electronics & Electricals and Modi Industries Ltd. (supra).      This appeal is, therefore, dismissed.  There will be no order as to costs. CIVIL APPEAL NOS.2/95, 198/89, 432/89 AND 433/89      Appeals are  dismissed in  view of  the above decision. There will be no order as to costs.      Civil Appeal No 2970/81      In this  appeal, we  are concerned  with the  following question;      "Whether on  the facts  and in  the      circumstances of the case, the sums      of   Rs.    38,98,970/-   and   Rs.      6,66,159/- constituted  reserve and      was  required   to  be  taken  into      account in  the computation  of the      capital under the Super Profits Tax      Act, 1963"      However, we  are concerned in this appeal only with the amount of  Rs. 6,66,159/- which was appropriated to gratuity reserve.   The question is whether this should be treated as reserve or  provision.   The point  is well  settled by  the decision of  this Court in the case of Vazir Sultan (supra). The answer  to the  question will  be that the amount of Rs. 6,66159/- will  have to  be treated  as  provision  and  not reserve.   We answer the question accordingly.  The order of the High Court to the above extent is set aside.      A point  has been  taken on  behalf of  the respondents that the  amount was more than what was actually required to be set  apart  as  liability  for  gratuity.    We  are  not expressing any opinion as to that because that is a question of fact.   It does not appear from the High Court’s order or the question  raised that  this point  was at  all in  issue before the Court or the Tribunal.      The assessee  can raise  this question, it can lawfully do so, before the Tribunal.  The appeal is allowed.