Supreme Court of India
Vazir Sultan Tobacco Co. Ltd.
Vs.
Commissioner of Income-Tax, Andhra Pradesh, Hyderabad
[1981] INSC 171 (25 September 1981)
TULZAPURKAR, V.D.
VENKATARAMIAH, E.S. (J) SEN, AMARENDRA NATH (J)
CITATION: 1981 AIR 2105 1982 SCR (1) 789 1981 SCC (4) 435 1981 SCALE (3)1483
CITATOR INFO : RF 1986 SC 484 (13,17) F 1986 SC1746 (6) R 1986 SC1938 (5,13,14,16,17)
ACT: Super Profits Tax Act, 1963 and Company’s (Profits) Sur-tax Act, 1964-Rule I of Second Schedule-Scope of- ‘Provision” and “Reserve’-Distinction- A sum of money transferred from current profits to general reserves- Dividend paid from that fund-General reserve how calculated.
HEADNOTE: The Super (Profits Tax) Act, 1963 and the Company’s (Profits) Sur-tax Act, 1964 (the scheme and main provisions of both of which are almost identical) impose a special tax on excess profits earned by companies. The special tax is imposed in respect of so much of a company’s “chargeable profits” of the previous year as exceeded the “standard deduction”- The term “chargeable profit” is defined to mean the total income of an assessee computed under the Income Tax Act, 1961 for any previous year and adjusted in accordance with the provisions of that Act. “Standard deduction” is determined by computing the capital of a company in accordance with the rules laid down in the schedule. The material part of rule I provides that before any amount or sum qualifies for inclusion in capital computation of a company two conditions are required to be fulfilled namely: (i) that the amount or sum must be a “reserve” and (b) that it must not have been allowed in computing the company’s profit for the purposes of Income Tax Acts, 1922 or 1961.
ln their respective balance sheets, the assessees had shown under the heading “current liabilities and provisions” appropriations of large sums of money for taxation, retirement gratuity and dividends and claimed that for the purposes of super profits tax these sums should be regarded as “other reserves” within the meaning of Rule 1 of Second Schedule to the Act and that for the computation of capital they should be taken into account.
Treating these sums as “provisions” and not as “reserves”, the Super Profits Tax officer determined the capital and the standard deduction by excluding them from the computation of the capital. He then levied super profits tax on that portion of the chargeable profits of the previous year as exceeded the standard deduction.
While the Appellate Assistant Commissioner upheld the assessee’s contention that these sums were “reserves” which should be taken into account for computing their capital, the Appellate Tribunal held that these were not “reserves” within 790 the meaning of Rule l of the Second Schedule to the Act and as such could not enter into capital computation.
On reference the High Court held that the sums set apart were not “reserves and so should be excluded in the computation of the capital for the purposes of levying the super profits tax.
In Tax Reference no. 5 (a case under the Companies (Profits) Sur-tax Act, 1964) the assessee transferred from out of its current profits a large sum of money to the general reserves and paid dividend to its shareholders from out of the augmented general reserves. On the question whether for computing the capital for the purpose of sur-tax the general reserves should or should not be reduced by the sum of dividend paid, the taxing authorities and the appellate tribunal ignored this amount holding that it was not a “reserve”.
None of the items of appropriation either for taxation or for retirement gratuity or for proposed dividend in the assessees’ cases had been allowed in computing their profits under the Income Tax Act, 1961.
HELD: [per Tulzapurkar & Venkataramiah, JJ] The expressions “reserve” and “provision” have not been defined in the Act. Standard dictionaries, without making any distinction between the two concepts, use them more or less synonymously connoting the same idea. But since in the context of the legislation a clear distinction between the two is implied it is essential to know the exact connotation of the two concepts and the distinction as known in commercial accountancy. The rules for computation of capital contained in the Second Schedule to the Act proceed on the basis of the formula of capital plus reserve, a formula well known in commercial accountancy. But since they occur in a taxing statute applicable to companies only these expressions will have to be understood in the sense or meaning attributed to them by men of business, trade and commerce and by persons interested in or dealing with companies. Therefore, the meaning attached to these words in the Companies Act, 1956 would govern their construction for the purpose of these two enactments [800 C-H] The broad distinction between the two expressions as judicially evolved by this Court is that, while a “provision” is a charge against the profits to be taken into account against gross receipts in the profit and loss account, a “reserve” is an appropriation of profits, the asset or assets by which it is represented being retained to form part of the capital employed in the business. [801 F] C.l.T. v. Ccntury Spinning & Manufacturiag Co., 24 ITR 499 and Metal Box Company of India Ltd. v. Their Workmen, 73 lTR 67 followed.
The Companies Act, which enjoins upon the Board of Directors of every company to lay before the annual general meeting of its shareholders an annual balance sheet and a profit and loss account, enumerates the separate heads that should be shown in the balance sheet, two of these items being “reserve’ and “provision”. The definitions of these two expressions given in the Act show 791 that if any retention or appropriation of a sum falls within the definition of A “provision” it can never be a “reserve”.
But the converse is not true. If the retention or appropriation is not a “provision” that is, if it is not designated to meet depreciation, renewals or diminution in value of assets or any known liability it is not automatically a “reserve” and the question will have to be decided having regard to the true nature and character of the sum so retained or appropriated depending on several factors, including the intention with which and the purposes for which such retention or appropriation had been made.
[803 E-Fl Having regard to the type of definitions of the two concepts, if a particular retention or appropriation of a sum falls within the expression “provision” then that sum will have to be excluded from the computation of capital. If the sum is in fact a “reserve” then it would be taken into account for the computation of capital. [804 B-C] Where the assessee had set apart a sum of money to meet tax liability in respect of profits earned during an accounting year, which liability was not quantified, such setting apart for a known and existing liability, would be a “provision” and could not be regarded as a “reserve”. [806 A-C] Kesoram Industries and Cotton Mills Ltd.v. Commissioner of Wealth Tax (central) Calcutta, 59 ITR 767 followed.
But if provision for a known or existing liability is made in excess of the amount reasonably necessary for the purpose, such excess should be treated as reserve” and, therefore, would be includible in capital computation. [806 E] Since the assessee (in C.A. No. 860/73) had at no stage of the proceedings before the Taxing Authorities or Appellate Tribunal or the High Court raised a plea that the provision made by it for taxation was in excess of the amount reasonably necesssary for the purpose and that such excess should be treated as a “reserve”, the plea which needs investigation into facts, could not be allowed to be raised for the first time in appeal before this Court. [807 F] Ordinarily an appropriation to gratuity reserve will have to be regarded as a provision made for a contingent liability, for, under a scheme framed by a company the liability to pay gratuity to its employee on determination of employment arises only when the employment of the employee is determined by death, incapacity, retirement or resignation-an event (cessation of employment) certain to happen in the service career of every employee. Moreover, the amount of gratuity payable is usually dependent on the employee’s wages at the time of G, determination of his employment and the number of years of service put in by him and the liability accrues and enhances with completion of every year of service; but the company can work out on an acturial valuation its estimated liability (i.e. discounted present value of the liability under the scheme on a scientific basis) and make a provision for such liability not all at once but spread over a number of years. If by adopting such scientific method any appropriation is made such appropriation will constitute a provision representing fairly accurately a known and existing liability for the year in question; if however, an ad hoc sum 792 is appropriated without resorting to any scientific basis such appropriation would also be a provision intended to meet a known liability, though a contingent one, for, the expression ‘liability’ occurring in cl. (7)(1)(a) of Part III of Sixth Schedule to the Companies Act includes any expenditure contracted for and arising under a contingent liability: but if the sum so appropriated is shown to be in excess of the sum required to meet the estimated liability (discounted present value on a scientific basis) it is only the excess that will have to be regarded as a reserve under clause (7) (2) of Part III to the Sixth Schedule. [807 G.H;
808 A-D] In the instant case although the assessee had urged before the authorities below that different treatment for the same item could not be given for purposes of income tax assessment and super profits tax assessment the assessee did not clarify by placing material on record as to whether appropriation was based on any acturial valuation or whether it was an appropriation of an ad hoc amount a which has a vital bearing on the question, whether the appropriation could be treated as a provision or reserve. In the absence of proper material the question should be decided by the taxing authorities whether the amount set apart and transferred to gratuity reserve by the assessee company was either a provision or a reserve and if the latter to what extent. [812 C-E] Standard Mills Co. Ltd. v. Commissioner of Wealth-Tax, Bombay, 63, I.T.R.470 & Workmen of William Jacks & Co. Ltd. v. Management of Jacks & Co.Ltd; Madras. [1971] Supp. S.C.R. 450 followed.
Southern Railway of Peru Ltd. v. Owen [1957] A.C. 334 referred to.
The appropriations of an amount by the Board of Directors by way of providing for proposed dividend would not constitute ‘provision’, for, the appropriations cannot be said to be by way of providing for any known or existing liability, none having arisen on the date when the Directors made recommendation much less on the relevant date after the first day of the previous year relevant to the assessment year in question. This by itself would not convert the appropriations into “reserves”. [813 E-F] The tests and guidelines laid down by this Court in this respect are: (1) the true nature and character of the appropriation must be determined with reference to the substance in the matter, which means that one must have regard to the intention with which and the purpose for which appropriation has been made such intention and purpose being gathered from the surrounding circumstances. A mass of undistributed profits cannot automatically become a reserve.
Somebody possessing the requisite authority must clearly indicate that a portion thereof has been earmarked or separated from the general mass of profits with a view to constituting it either a general reserve or a specific reserve; (2) the surrounding circumstances should make it apparent that the amount so earmark ed or set apart is in fact a reserve to be utilised in future for a specific purpose on a specific occasion; (3) a clear conduct on the part of the Directors in setting apart a sum from out of the mass of undistributed profits avowedly for the purpose of distribution of dividend in the same year would run counter to any intention of making that amount a reserve, (4) the nomenclature accorded to any particular fund which is set apart from out of the profits would not be material 793 Or decisive of the matter; and (5) if any amount set apart from out of the profits A is going to make up capital fund of the assessee and would be available to the assessee for its business purposes it would become a reserve liable to be included in the capital computation of the assessee under that Act. [815 F-H, 817 G] The relevant provisions of the Companies Act clearly show that creating reserves out of the profits is a stage distinct in point of fact and anterior in point of time to the stage of making recommendation for payment of dividend and the scheme of the provisions suggests that appropriation made by the Board of Directors by way of recommending a payment of dividend cannot in the nature of things be a reserve. [818 F-G] Judged in the light of the above guidelines the appropriations made by the Directors for proposed dividend in the case of the concerned assessee companies did not constitute ‘reserves’ and the concerned amounts so set apart would have to be ignored or excluded from capital computation. [818 H] Standard Mills Co. Ltd. v. Commissioner of Wealth-tax Bombay, 63 I.T.R.470, Metal Box Co. Of India Ltd. v. Their Workmen, 73 ITR 67, First National City Bank v. Commissioner of Income-Tax, 42 ITR 67 & Commissioner of Income- tax (Central), Calcutta v. Standard Vacuum oil Co., 59 ITR 685 followed.
Although under the Companies Act it is open to the Directors to recommend and the share-holders to approve payment of dividend from the current year’s profits or from the past year’s profits and on transfer of a portion of the current year’s profit to the general reserve the augmented general reserve becomes a congolmerate fund, having regard to the natural course of human conduct it is not difficult to predicate that dividends would ordinarily be paid out from the current income rather than from the past savings, unless the directors in their report expressly or specifically state that payment of dividends would be made from the past savings. From the commercial point of view, if any amount is required for incurring any expenditure or making any disbursement like distribution of dividends in a current year, ordinarily the same will come out of the current income of the company if it is available and only if the sum is insufficient then the past savings will be resorted to for the purpose of incurring that expenditure or making that disbursement. Such a course would be in accord with the common sense point of view. [822 C-F] In the absense of express indication to the contrary the normal rule for a commercial concern would be to resort to current income rather than past savings while incurring any expenditure or making any disbursement. [822 H] Commissioner of Income-Tax, Bombay City-l v. Bharat Bijlee Ltd. 107 ITR 30; & Commissioner of Income-Tax, Bombay City-ll v. Marrior (India) Ltd. 120 ITR Sl 2 approved.
[per A.N. Sen, J.] The amount set apart for payment of any dividend recommended by the Board of Directors is not an amount set apart for meeting a known or existing 794 liability and cannot be considered to be a “reserve” within the meaning of the Act for the purposes of computation of the capital of the company. [832 F] The Companies Act, 1956 provides for the preparation of annual balance sheet in the prescribed form and laying it before the shareholders at the annual general meeting.
Regulation 87, Table A in Schedule I contemplates that the Board may set aside out of the profits of the company certain sum as “reserve” before dividend is recommended by it. The amount recommended by the Board for payment of dividend is shown in the balance sheet under the head “provision” and not under any head of “reserve”. The true nature and character of the sum so set apart must be determined with regard to the substance of the matter which in this case is that the sum set apart was never intended to constitute a “reserve’ of the company. [833 F, 834G] In law the liability for payment of dividend arises only when the share-holders accept the recommendations made by the Directors. Till then it is open to the Directors to modify or withdraw their recommendation before it is accepted by the shareholders and it is equally open to the share-holders not to accept the recommendation in its entirety. Even so, for business purposes when the Directors make any recommendation for payment of dividend and set apart any amount for this purpose the Directors intend to make a provision and do not create any reserve, as Directors know that their recomendation is generally accepted by the shareholders as a matter of course. Therefore any amount set apart for this purpose is understood by persons interested in company matters and in dealing with companies to mean a provision for the payment of dividend to the shareholders and is not understood to constitute a “reserve”. [832 C-F] Commissioner of lncome-tax Bombay City v. Century Spinning and Manufacturing Co. Ltd. [1953] 24 I.T.R. 499, Commissioner of Income Tax v. Standard Vaccum oil Co., [1966] 59 I.T.R. 685, Metal Box Co. Of Ltd. v. Their Workmen, [1963] 73 I.T.R, 53, Commissioner of Income-tax v. Mysore Electrical Industries Ltd., [1971] 80 l.T.R. 567 and Kesho Ram Industries and Cotton Mills Ltd v.Commissioner of Wealth Tax (Central), Calcutta, [1966] 59 I.T.R. 767 referred to.
CIVIL APPELLATE JURISDICTION: Civil Appeal No. 860 of 1973.
From the judgment and order dated the 1st September, 1972 of the Andhra Pradesh High Court at Hyderabad in R.C. No. 10 of 1971.
AND Civil Appeal No. 1614 (NT) of 1978.
Appeal by Special Leave from the judgment and order dated the 26th July, 1976 of the Calcutta High Court in l.T. Reference No.454 of 1974.
AND Review Petition No. 57 of 1980.
795 IN Special Leave Petition (Civil) No. 4602 of 1977 From the judgment and order dated the 11th June, 1974 of the Calcutta High Court in I.T. Reference No. 195 of 1969.
AND Tax Reference Case Nos. 2 and 3 of 1977.
Income-tax Reference under section 257 of the Income- tax Act, 1961 drawn up by the Income-tax Appellate Tribunal, Bombay Bench ‘B’ in R.A. Nos. 1223 and 1224 (Bom.) of 1972- 73 (I.T. A. Nos. 24 and 25 (Bom.) of 1971-72.
AND Tax Reference Case No. S of 1978.
Income Tax Reference under section 257 of the Income Tax Act, 1961 made by the Income Tax Appellate Tribunal, Bombay Bench “D” in R.A. No. 225 (Bom.) of 1977-78 arising out of S.T.A.No. 36 (Bombay) 1 1976-77.
