1505. Whether credit balance in profit and loss account can be treated as reserve for computing capital of company

This question [as to whether the credit balance in the profit and loss account can be treated as a reserve] was considered by the Supreme Court in CIT v. Century Spg. & Mfg. Co. Ltd. [1953] 24 ITR 499 in the context of rule 2(1) of the Schedule to the Business Profits Tax Act under which the reserves were treated as forming part of the capital of a company, as under the Super Profits Tax Act. In that case the company held a credit balance of over Rs. 5 lakhs in its profit and loss account as on April 1, 1946. The question for decision was whether in computing the capital of the company as on April 1, 1946 (which was the first day of the chargeable accounting period for Business Profits Tax) the said credit balance in the profit and loss account could be treated as a reserve. The Supreme Court held that the amount could not be treated as a reserve. It observed :

“On April 1, 1946, which is the crucial date, the sum …. could not be called a ‘reserve’ for no body possessed of the requisite authority had indicated on that date the manner of its disposal or destination. It remained on April 1, as a mass of undistributed profits which were available for distribution and not earmarked as ‘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…..cannot automatically make it a reserve…..Thus, the profit lying unutilised and not specially set apart for any purpose on the crucial date did not constitute reserve……”

This decision is also applicable to the interpretation of the meaning of the term “reserve” with reference to the provisions of the Second Schedule to the Super Profits Tax Act, 1963.

In this connection, it may be mentioned that in accordance with the principles of accountancy, reserve consists of appropriation from profits and other surpluses which have been earned in the past, being amounts which are not designed to meet any liability, contingency, commitment or diminution in the value of assets known to exist as at the date of the balance-sheet. The general objects of creating a reserve are to make a provision for promoting financial stability, equalising dividends, providing for future expansions and for replacements of assets at increased prices, avoiding declaration of excessively high dividends in years of prosperity, meeting possible losses peculiar to the character of the company’s operations, reducing loans (debentures) or redeemable preference shares or setting aside savings for future taxation.

Circular : No. 1-D(SPT) of 1963 (relevant extracts), dated 28-10-1963.

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