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Judgment
P.B. Sawant, J.—The question that falls for consideration in the present reference relates to the computation of the capital base of the assessee under the Super Profits Tax Act, 1963 (hereinafter referred to as "the Act"), and the precise question is whether secret reserves maintained by the assessee-bank are includible in the capital of the assessee. The assessee is a banking company and the assessment year is 1963-64 when the Act was applicable to the assessee. The computation of the super profits tax is to be made in accordance with the rules given in the Act. The rules contained in the Second Schedule to the Act provide for the computation of capital base which computation is necessary for arriving at the standard deduction. The profits which are in excess over the standard deduction are only liable to super profits tax. Hence, the computation of standard deduction assumes significance.
The assessee-bank computed its capital for the purpose of calculating super profits tax and in doing so it took into consideration the following items as constituting its reserves, viz., (i) Rs. 76,58,687 which represented the amount standing to the credit of premium and discount account but which was not shown in its balance sheet; (ii) Rs. 1,31,00,548 being the taxation reserve; and (iii) Rs. 85,84,302 which were the depreciation reserve.
It is common ground that the first amount of Rs. 76,58,687 did not figure in the published balance sheet of the bank and this was stated to be the amount merged in investments shown in item (4) of the balance sheet relating to the year ending on 31-12-1961. Normally, the balance sheet for the assessment year in question, viz., 1963-64, would be the balance sheet as on 31-12-1962 in relation to the calendar year 1962 which is the accounting year followed by the assessee-bank. However, since for super profits tax we are concerned with the first day of the previous year for the computation of capital, it is necessary to look into the figures in the balance sheet relating to the year prior to the previous year and hence, we are concerned with the balance sheet as on 31-12-1961.
The said investment in the balance sheet showed a sum of Rs. 22,24,12,868.18 under the head "Security and share account". A break up of this figure was produced before the Tribunal to show how the amount of Rs. 76,58,687 was made up. The said break up is as follows:
Rs.
P.
Debit balances of security and share accounts
23,00,71,555.37
Less : Credit balance of premium and discount balances
76,58,687.19
22,24,12,868.18
The ITO negatived the claim with regard to this amount as reserve on the ground that the said reserve was not created by the requisite authority.
With regard to the taxation reserve of Rs. 1,31,00,548, the ITO took the view that only the excess over the known liability should [be considered as reserve. According to him, the said excess was Rs. 39,33,579, and allowed only the said sum as reserve. The difference between Rs. 1,31,00,548 and Rs. 39,33,579 was the amount in dispute. The ITO, however, by mistake has stated in his order that the claim for taxation reserve was for a sum of Rs. 1,22,28,421. The AAC in appeal correctly took the sum as Rs. 1,31,00,548. Hence, the amount in dispute was Rs. 91,66,969 and not Rs. 39,33,579 (which was allowed by the ITO as a reserve) on the basis of the correct figure as taken by the AAC as Rs. 1,31,00,548.
As regards the depreciation reserve, the ITO has held that the inclusion of depreciation reserve could not be allowed since the bank had no reserve as such but had only claimed the amount written off from the various assets after deduction of depreciation there from as reserve. Though the amount mentioned was Rs. 85,84,302 before the ITO and the AAC and, at the time of the hearing of this appeal, before the Tribunal, at the time of the application for making a reference it was admitted that the correct claim was only to the extent of Rs. 69,03,280 under this head.
Against the order of the ITO, the assessee- bank preferred an appeal and in the appeal the AAC confirmed the finding of the ITO with regard to all the three amounts. The assessee carried the matter further in appeal to the Tribunal. With regard to the first amount, the Tribunal took the view that the said amount constituted moneys kept available for the use of the bank and though this account was not styled as reserve, it was kept to meet some eventualities and, therefore, it could be treated on par with the reserve for contingency. The Tribunal further accepted that there may not be an express authorisation of the board on this account and in this connection observed that a decision regarding a secret matter of this nature could not be taken by an executive action; the matter being a vital and a crucial one, the decision would rest with the board alone and it alone could take and assume responsibilities in that behalf. The Tribunal, therefore, held that such a reserve must have been created with the requisite authority from the board of directors though the evidence of such authority was not available. The Tribunal also took the view that the transfers to the said account could not be made by an express act of authority as in the case of other appropriations which were brought to the notice of the shareholders and the members of the public. The Tribunal, therefore, held that the said premium and discount account was reserve and, therefore, was eligible to be considered as capital base for computation of capital base under the Act. As regards the taxation reserve, the Tribunal took the view that it was a provision and not a reserve. As regards the third amount of depreciation, the Tribunal felt that the very existence of such reserve was not proved to the hilt and, therefore, the view taken by the AAC and the ITO in the matter could not be disturbed.
The revenue thereafter made an application to the Tribunal for reference u/s 256(1) of the income tax Act, 1961 read with section 19 of the Act and at the hearing of the said reference application, with regard to the Tribunal''s finding that the said amount of Rs. 76,58,687 was includible in the computation of the capital base of the assessee, the assessee raised two questions, viz., one relating to the non-inclusion of the taxation reserve and the other with regard to the non-inclusion of the depreciation reserve for the computation of its capital base. The Tribunal relying on a decision of this Court in Girdhardas and Co. Ltd. Vs. Commissioner of Income Tax, Ahmedabad, , held that although the assessee had not made a separate application of its own to make a reference of the said two questions to the Tribunal, the Tribunal was empowered to refer the questions raised by the assessee also, along with the questions sought to be referred by the revenue. Hence, the Tribunal made a reference of the following three questions to this Court:
Whether, on the facts and in the circumstances of the case, it has been rightly held that the sum of Rs. 76,58,687, being the amount standing to the credit of premium and discount account, was a reserve to be added to the capital under rule 1 of the Second Schedule to the Super Profits Tax Act?
Whether, on the facts and in the circum stances of the case, it has been rightly held that out of the sum of Rs. 1,31,00,548 standing to the credit of the Taxation Reserves Account as on 1-1-1962 the amount of the known tax liability did not constitute a reserve for the purposes of rule 1 of the Second Schedule to the Super Profits Tax Act?
Whether, on the facts and in the circumstances of the case, it has been rightly held that to the extent of the sum claimed by the respondent in respect of the excess depreciation provided over the income tax depreciation as depreciation reserve, it did not constitute a reserve for the purposes of rule 1 of the Second Schedule of the Super Profits Tax Act?
It is now conceded by Shri Dastur appearing for the assessee that in view of the decision of the Supreme Court in Commissioner of Income Tax, Kerala Vs. V. Damodaran, the last two questions could not have been referred by the Tribunal in an application for reference by the revenue. Hence, it is not necessary for us to answer the said two questions. As stated earlier, therefore, the question that falls for consideration in this case is whether the Tribunal was right in its view that the said amount of Rs. 76,58,687 representing the balance standing in the premium and discount account and not disclosed in the published balance sheet of the assessee-bank could be treated as a reserve and included in the capital base for the purpose of calculation of excess profits under the Act.
Admittedly, the assessee-bank has been treating this amount as what is called a secret reserve and as has been stated earlier, it was not shown in the published balance sheet for the relevant year. It is also not disputed that there is no record of the authority to authorise the appropriation of the said amount to the said secret reserve account. Not only that, but the amount does not appear in so many figures anywhere and it has to be inferred from the relevant entries in the balance sheet. The entries in the balance sheet also would not indicate any particular amount as being on account of the profit and loss incurred due to the sale of the shares or securities since the amount standing to the said account at any particular point of time does not constitute entirely of the said amount but also consists of amounts appropriated from time to time from the profit and loss account. According to the assessee, the said amount which is shown under premium and discount account represents the balance standing to the credit of the said account on the first day of the previous year which is the relevant day for accounting purposes and all the profits and losses made on account of the sale of the shares and securities are credited to this account. According to the assessee, the bank enjoys certain privileges under which it could withhold certain information from the published balance sheet in the interests of healthy banking practice and, therefore, this account could not form part of the balance sheet; but the books of account did show the said amount. They were in the nature of hidden reserve and it was not disputed that the said funds were utilised and employed in the business. According to the assessee, no requisite appropriation would be necessary for an account of this type as there was a continuous and implied authority for appropriation in view of the special privileges enjoyed by the bank. It was, therefore, submitted before the Tribunal that all the transfers could be done without the requisite authority.
As against this, it was the contention of the revenue that it would lead to absurd results if all such items claimed by the bank were considered as reserves and this would result in the capital base becoming so large that no super profits would ever arise. The revenue, therefore, insisted that the capital employed should be strictly construed and only that amount should be allowed to be computed as capital which was expressly permitted by the rules under the Act.
Before we deal with the relevant controversy, it will be necessary first to refer to the provisions of the Act in that behalf. u/s 4 of the Act, there shall be charged on every company for every assessment year commencing on and from 1-4-1963, a tax, called the super profits tax, in respect of so much of its "chargeable profits" of the previous year as exceed the "standard deduction", at the rate or rates specified in the Third Schedule. Section 2(5) defines the expression "chargeable profits" 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 the First Schedule. Section 2(9) defines the expression "standard deduction" to mean an amount equal to six percent of the capital of the company as computed in accordance with the provisions of the Second Schedule, or an amount of Rs. 50,000, whichever is larger. In order to determine "standard deduction" it becomes necessary to compute the capital of the company in accordance with the rules laid down in the Second Schedule, and rule 1, which is relevant for our purpose, so far as it is material, is as follows:
Subject to the other provisions contained in this Schedule, the capital of a company shall be the sum of the amounts, as on the first day of the previous year relevant to the assessment year, of its paid-up share capital and of its reserve, if any, created under the proviso (b) to clause (vib) of sub-section (2) of section 10 of the Indian income tax Act, 1922, or under sub-section (3) of section 34 of the income tax Act, 1961, and of its other reserves insofar as the amounts credited to such other reserves have not been allowed in computing its profits for the purposes of the Indian income tax Act 1922, or the income tax Act, 1961,....
Thus, it is clear from the aforesaid provision of rule 1 that before any amount qualifies for inclusion in capital computation of a company, two conditions should be fulfilled: (i) that the amount must be a "reserve", and (ii) the same must not have been allowed in computing the company''s profits for the purpose of the Indian income tax Act, 1922 or the 1961 Act. It is not disputed that the present amount had not been allowed in computing the assessee''s profits under the 1961 Act. Therefore, the second condition has been satisfied. The only question that requires to be answered is whether the said amount falls within the expression "reserve" occurring in the Rules and satisfies the first condition.
What is reserve has been explained by this Court in its decision in the case of Shree Ram Milis Ltd. Vs. Commissioner of Income Tax, Bombay City-I, . The sum and substance of the law laid down by this Court in that behalf is that if the amount set aside is not designed to meet a liability, contingency, commitment or diminution in the value of assets known to exist at the date of the balance sheet, it will qualify itself to be called a reserve. There is no definition of reserve given under the Act and, therefore, the general definition of reserve will have to be made applicable for finding out whether the amount in question falls in the said category. Two more decisions will have to be referred to in this connection. They are: a decision of the Supreme Court in Commissioner of Income Tax, Bombay City Vs. The Century Spinning and Manufacturing Co. Ltd., and a later decision of the Calcutta High Court in Indian Steel and Wire Products Ltd. Vs. Commissioner of Income Tax, West Bengal, Calcutta, . Both these decisions are under the Business Profits Tax Act, 1947. In the Supreme Court decision, the question that fell for consideration was whether the balance of Rs. 5,08,637, which was carried to the balance sheet after making a provision for depreciation and taxation, constituted: reserve within the meaning of rule 2(1) of the Second Schedule to the Act. The facts in that 1 case were that for the year ending 31-12-1945, the profit of the assessee-company, whose accounting year was the calendar year, was a certain sum according to the profit and loss account. After making provision for depreciation and taxation as stated earlier, the balance of Rs. 5,08,637 was carried to the balance sheet. This sum was not allowed in computing the profits of the assessee for purposes of income tax. In February 1946, the directors recommended that out of that amount a sum of Rs. 4,92,426 should be distributed as dividend and the balance of Rs. 16,211 should be carried forward to the next year''s account. This recommendation was accepted by the shareholders in their meeting held on 3-4-1946 and the amount was shortly thereafter distributed as dividend. In computing the capital of the assessee-company on 1-4-1946, under the Business Profits Tax Act, 1947, the assessee claimed that the said sum of Rs. 5,08,637 and the profit earned by it during the period 1-1-1946 to 1-44946 should be treated as reserves for the purpose of the said rule. The High Court held that the sum of Rs. 5,08,637 must be treated as a reserve for the purpose of the said rule, but the profit made by the assessee during the period 1-1-1946 to 1-4-1946, could not be included in the reserves. On appeal, the Supreme Court held that both the said sum of Rs. 5,08,637 as well as the profit earned by the assessee during the relevant period did not constitute reserves within the meaning of the said rule. While discussing whether the amount in question could be called a reserve, the Supreme Court held as follows:
The term ''reserve'' is not defined in the Act and we must resort to the ordinary natural meaning as understood in common parlance. The dictionary meaning of the word ''reserve'' is:-
''I (a) To keep for future use or enjoyment; to store up for some time or occasion; to refrain from using or enjoying at once.
(b) To keep back or hold over to a later time or place or for further treatment.
To set apart for some purpose or with some end in view; to keep for some use.
II. To retain or reserve for certain purposes'' (Oxford Dictionary, Vol. VIII, p. 513).
In Webster''s New International Dictionary, 2nd edition, p. 2118, ''reserve'' is defined as follows:-
To keep in store for future or special use; to keep in reserve; to retain, to keep, as for oneself.
To keep back; to retain or hold over to a future time or place.
To preserve.''
What is the true nature and character of the disputed sum, must be determined with reference to the substance of the matter and when this is borne in mind, it follows that on the 1st of April, 1946, which is the crucial date, the sum of Rs. 5,08,637 could not be called a ''reserve'' for nobody possessed of the requisite authority had indicated on that date the manner of its disposal or destination. On the other hand, on the 28th February, 1946, the directors clearly earmarked it for distribution as dividend and did not choose to make it a reserve. Nor did the company in its meeting on the 3rd April, 1946, decide that it was a reserve. It remained on the 1st of April as a mass of undistributed profits which were available for distribution and not earmarked as ''reserve''. 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 had decided to earmark it for distribution as dividend. By the resolution of the shareholders on the 3rd April, 1946, the amount was shortly afterwards distributed as dividend.... The directors had no power to distribute the sum as dividend. They could only recommend, as indeed they did, and it was up to 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 unutilised and not specially set apart for any purpose on the crucial date did not constitute reserves within the meaning of Schedule II, rule 2(1)." (pp. 503-05)
In this context, while discussing the provisions of sections 131(a) and 132 of the Indian Companies Act, the Court held as follows:
Reference was made to sections 131(a) and 132 of the Indian Companies Act. Section 131(a) enjoins upon the directors to attach to every balance sheet a report with respect to the state of 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. The latter section refers to the contents of the balance sheet which is to be drawn up in the Form marked F in Schedule III. This Form contains a separate head of reserves. Regulation 99 of the 1st Schedule, Table A, lays down ''that the directors may, before recommending any dividend set aside out of the profits of the company such sums as they think proper as a reserve or reserves which shall, at the discretion of the directors, be applicable for meeting contingencies, or for equalising dividends, or for any other purpose to which the profits of the company may be properly applied....'' The regulation suggests that any sum out of the profits of the company which is to be made as a reserve or reserves must be set aside before the directors recommend any dividend. 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 also support the conclusion as to what is the true nature of a reserve shown in a balance sheet." (p. 505)
The above observations of the Supreme Court therefore make it clear that the amount sought to be claimed as reserve must be deter mined with reference to the substance of the matter. It must further be clearly earmarked and appropriated as reserve and what is more, such appropriation or earmarking must be done by an authority who has power to ear mark or appropriate the sum as reserve.
In Indian Steel''s case (supra) the Calcutta High Court has emphasised the very same aspect, viz., that before an amount is treated as reserve, the company has to indicate the manner of its disposal or destination. If the surplus is simply carried forward without the persons in requisite authority allocating it to any particular purpose as a reserve, it does not acquire the character of a reserve for the purposes of capital computation under the Business Profits Tax Act. In that case, the balance sheet of the assessee-company for the year ending 31-3-1946 showed a sum as unappropriated balance. This sum was made up of two smaller sums, viz., (i) an amount which had been carried forward out of the balance as at the last date of the previous year, i.e., as on 31-3-1945, and (ii) an amount which was the balance of the profits for the year 1945-46. The assessee claimed that it was entitled to have the entire sum treated as reserve for the purposes of the computation of its capital for the chargeable accounting period ended 31-3-1947 under rule 2(1) of the Second Schedule to the Business Profits Tax Act, 1947. The Tribunal allowed the assessee''s claim with regard to the amount carried forward from the previous year 1944-45 but rejected its claim in respect of the balance of the profits for the year 1945-46. The High Court on reference held that as the company had not indicated the manner of the disposal or the destination of the balance of the profits of the previous year 1944-45 as well as the profits of the year 1945-46, neither amount could be considered to be a reserve for the purposes of the said rule. According to the High Court, if the surplus is simply carried forward without the persons in requisite authority allocating it to any particular purpose as a reserve, it does not acquire the character of a reserve for the purposes of capital computation under the Business Profits Tax Act.
These two decisions, therefore, make the position in law clear on the point, viz., that the amount has to be specifically earmarked or appropriated as reserve and that such appropriation has to be done by the requisite authority. A mere carrying forward of an amount or a surplus profit without such requisite authority would not acquire the character of a reserve for the purposes of capital computation under the Act. It is in the light of this position in law that we have to examine whether the amount in question constitutes a reserve. It is also interesting to note that in the present case the claim is not only that the amount in question is a reserve but that it is a secret reserve and that the assessee is entitled to maintain such secret reserve and the same is entitled to be calculated in the capital base of the assessee for the purposes of calculation of surplus profits under the Act. It will, therefore, also be necessary to find out what exactly is meant by secret reserve and whether the assessee is entitled to maintain such secret reserves.
In the course of the arguments, both sides referred us to some authoritative text books on book-keeping and accounts where a reference to secret reserve and to the method and manner of maintaining them has been made. In Spicer & Pegler''s Book-keeping and Accounts, 17th edition at p. 68, the term "secret reserves" has been explained as follows:
The term ''secret reserves'' is used to denote reserves which exist but are not disclosed on the face of the balance sheet.
Secret reserves may arise in two ways, viz., by the deliberate action of creating them, or by unrecorded appreciation in value of assets. It would normally be unusual to write up assets for an unrealized appreciation in value, hence the appreciation is not as a rule shown on the face of the balance sheet.
Secret reserves may be created deliberately by:
Writing down assets below their market value by excessive provision for depreciation.
Writing off assets altogether, although they are still of value.
Creating excessive provisions for bad debts.
Charging capital expenditure to revenue.
Omitting goodwill from the accounts.
Overstating liabilities in the balance sheet.
Treating reserves for contingencies as pro visions for specific liabilities.
Grouping free reserves with liabilities, so as to inflate the liabilities on the balance sheet.
Crediting exceptional or non-recurring pro fits direct to a contingencies reserve, and including such reserves in the liabilities on the balance sheet.
The following objections may be made against the practice of creating and maintaining secret reserves:
The resulting balance sheet will not disclose a true and fair view as the assets will be under stated and/or the liabilities overstated.
The profit and loss account, where affected will not show the correct profit, and consequently the dividend declared may be less than would otherwise have been possible.
The practice could lend itself to the manipulation of profits, and to improper dealings in the shares of a company by persons who were aware of the existence of the secret reserves.
If the use of secret reserves to pay dividends is not disclosed in the published accounts, members will not know that the revenue for the period was insufficient to pay the dividends. The true trading results may thus be obscured.
Assets, once depreciated, cannot be written up without attracting attention, whereas reserves for contingencies, being merged with creditors, can be manipulated with little risk of discovery. Hence, overstatement of liabilities is open to more objection than under valuation of assets.
On the other hand the practice of creating secret reserves is often advantageous; banks and insurance companies can maintain the payment of dividends without violent fluctuations, and exceptional losses need not harm their credit, which although alarming to the uninitiated, do not shake their stability.
In Pickles & Lafferty''s Accountancy, 4th edition, reference is made to reserves which are not disclosed in the balance sheet and they are classified as hidden reserves, inner reserves and secret reserves. They have been described as follows:
Hidden reserves, where an item of profit is (including revenue or capital reserve) described in such a manner as to indicate a liability, being included, for instance, in sundry creditors.
Inner reserves, where a provision is made to cover exceptional and abnormal losses, and such provision is not openly disclosed, e.g., general contingencies reserve (in the case of a bank) included in creditors usually under the heading, of ''Deposit, current and other accounts''.
Secret reserves, where the net asset position is stronger than that disclosed by the balance sheet by reason of:
(a) Excessive depreciation of an asset (particularly, goodwill), or excessive valuation of a liability, or excessive provisions;
(b) complete elimination of an asset; under valuation or understatement of an asset;
(c) charging capital expenditure to revenue, or crediting revenue receipts to an asset (e.g., dividends received and earned credited to the investment);
(d) permanent appreciation in a fixed asset, or permanent diminution or extinction of liability not recorded;
(e) showing a contingent liability as an actual liability or as a provision therefore, or an actual asset as a contingent asset;
(f) grouping of ''free'' reserves with creditors;
(g) crediting exceptional or non-recurring profit to a contingencies reserve without proper disclosure; and
(h) allowing undistributed surplus in the hands of a subsidiary company.
An example of the creation of a secret reserve is seen where a bank provides for depreciation investments, but does not recredit a subsequent appreciation of investments.
From this, it will be seen that secret reserves may-
(i) arise, as in (d)
(ii) be created, as in the remainder of the examples given,
(iii) be maintained, by allowing (i) to remain or by continuing the practice in (ii).
So also in Batliboi''s Advanced Accountancy, 27th edition at p. 724, a similar explanation is given with regard to secret or inner reserves.
It will thus appear from the aforesaid description of secret reserves given in the text-books that there are various modes of forming secret reserves and one of the ways is to undervalue the stocks of shares and securities. Since such an operation reduces the value of the assets without the fact being disclosed in the balance sheet, they become secret and hidden and are known only to the management. It is also observed in these books that nearly all banks and financial institutions have such secret and inner reserves. Whether they are excessive or not can only be decided by examination of their intention. The justification for secret reserves is that the directors sometimes experience a reluctance on the part of the shareholders to deny themselves a full distribution of profits in order to form reserve funds, and also a desire to average one year''s profits with another. The equalisation of profits in this manner not only gives a business the impression of stability but helps to ensure a regular income to the shareholders. Secret reserves enable the business to meet extraordinary losses without the same being disclosed and thus prevent the public confidence being shaken.
It will now be advantageous to refer to the Banking Regulation Act, 1949 which was applicable to the assessee and which lays down the manner in which the assessee was at the relevant time liable to maintain accounts and publish its balance sheet. Section 29 contains a provision with regard to maintenance of accounts and balance sheet. It states that the balance sheet and profit and loss account of the banking company will be in the forms set out in the Third Schedule and that it shall be signed by the manager or the principal officer of the company, and where there are more than three directors of the company, by at least three of those directors, or where there are not more than three directors by all the directors. The form in which the profit and loss account is to be maintained is Form B of the Third Schedule and on its income side, a column is provided which enables the banking company to state the income (less provision made for bad and doubtful debts and other usual or necessary provisions). This income is to be included in the item which is described as net profit on sale of investments, gold and silver, land, premises and other assets (not credited to reserves or any particular fund or account). It is clear from this provision of section 29, read with Form B, that the Act envisages that there will be profits on sale of investments of the company which may not be credited to reserves or any particular fund or account as shown in the balance sheet. Further, the provision that the balance sheet and the profit and loss account will have to be signed, whenever there is a board of directors, by the directors show that the statement made in the balance sheet and the profit and loss account when signed will be deemed to have been perused by them and their appropriation of the amounts to the different accounts will be deemed to have been done under their authority.
Section 30 refers to the audit of the account; section 31 refers to the submission of returns by the assessee to the Reserve Bank and section 32 contains a provision with regard to furnishing of balance sheets and accounts to the Registrar under the Companies Act. Section 34A then lays down that no banking company shall be compelled by any authority to produce or give any inspection of its books of account or any document or furnish or disclose any statement or information in any proceeding before it when the banking company claims that such document, statement or information is of a confidential nature and such information would disclose information relating to any reserves not shown as such in its published balance sheet or any particulars not shown therein in respect of provisions made for bad and doubtful debts and other usual or necessary provisions. The provisions of this section themselves imply that there may be reserves other than those shown in the published balance sheet. These provisions, therefore, impliedly recognise the practice of maintaining secret, inner or hidden reserves.
Section 35 provides for inspection of the banking company''s accounts by the Reserve Bank. Section 35A gives power to the Reserve Bank to give directions to the banking company in the public interest or in the interest of the banking policy or to prevent the affairs of the company being conducted in a manner detrimental to the interests of the depositors or prejudicial to the interests of the banking company or to secure its proper management in general. The provisions of sections 35 and 35A make it clear that the Reserve Bank has an overriding power to supervise and control the affairs of the banking company which includes the power of inspection of all books, accounts and other documents of the company. This will undoubtedly include the power to inspect books of accounts which show the hidden or secret reserves.
It will be interesting in this connection to make a reference to a decision of the Supreme Court in All India Bank Employees'' Association Vs. National Industrial Tribunal and Others, . In this case the constitutional validity of the said section 34A of the Banking Regulation Act, was challenged on the ground that it was ultra vires articles 19(1)(c) and 14 of the Constitution. While upholding the validity of the said section, the Supreme Court had to discuss the practice of maintaining secret reserves and this is what the Court had to say, with reference to the said practice, in paragraph 31 of its judgment:
From what we have stated earlier as, the genesis of the legislation now impugned, it would be apparent that Government had to effect a reconciliation between two conflicting interests: one was the need to preserve and maintain the delicate fabric of the credit structure of the country by strengthening the real as well as the apparent credit worthiness of banks operating in the country. It was really this principle which is vital to the economic life of the community that has been responsible for the changes that have been made from 1927 onwards as regards the form of balance sheets and of the profit and loss accounts of banking companies as distinguished from other trading and industrial organizations. There was urgent need to protect from disclosure of the certain items of appropriation by banks in order to preserve them as credit institutions. On the other hand, there was the need-an equally urgent need-for enabling the workers in these institutions not to be denied a proper wage and other emoluments and proper conditions of services. The question was how far information which in the interests of national economy the banks were entitled to withhold from their shareholders and the general public, was to be made available for determining the capacity of the banks to pay their employees. It was in these circumstances that the impugned legislation was enacted which, while preserving industrial adjudication in respect of disputes between the banks and their employees, entrusted the duty of determining the surplus reserve which could be taken into account as part of the assets for determining capacity to pay, to the Reserve Bank. Thus understood there does not appear to be anything unreasonable in the solution which the impugned legislation has effected.
These observations will further show that even the Supreme Court has accepted the practice of the banking companies'' maintaining secret reserves which are not disclosed in the balance sheet but which are necessary in the interests of national economy, preservation and maintaining the delicate fabric of the credit structure of the country by strengthening the real as well as the apparent credit worthiness of banks operating in the country. The provisions of the Banking Regulation Act, therefore, in terms permit the maintenance of such secret reserves in the interest of healthy banking practice. The said provisions also further show that the balance sheets and profit and loss accounts are to be signed by the directors and, therefore the allocation shown in the balance sheet and the profit and loss account should always be deemed to have been done at the instance of the directors. The balance sheet and the profit and loss accounts are only summary of the books of account of the company. It is not disputed that the secret reserves though not shown in the balance sheet and profit and loss accounts find their place in the books of account and are reflected therein. Hence, on the reading of the provisions of the Banking Regulation Act, it will have to be held that secret reserves are maintained and allocation of the profits to such reserves is done at the instance of the board of directors of the company.
This position in law also emerges from a reading of the Companies Act, 1956. Section 211 of the Companies Act provides for the form and contents of the balance sheet, and profit and loss account of the company registered under the Act. The assessee like any other banking company is also registered under the said Act.
Sub-section (2) of the said section provides that every profit and loss account of a company shall give a true and fair view of the profit or loss of the company, and comply with the requirements of Part II of Schedule VI, so far as they are applicable thereto.
Sub-section (5) thereof then states that the balance sheet and the profit and loss account of a company shall not be treated as not disclosing a true and fair view of the state of affairs of the company, merely by reason of the fact that they do not disclose, in the case of a banking company, any matter which is not required to be disclosed by the Banking Regulation Act, 1949. As pointed out earlier by virtue of section 34A of the Banking Regulation Act, the banking company is entitled not to disclose, among other things, its secret reserves. Hence the balance sheet as published by any banking company will have to be taken as disclosing or reflecting true and fair affairs of the company and cannot be questioned for want of express information with regard to the secret reserves. This will also mean that if the company claims that it has maintained secret reserves, that claim will have to be accepted in spite of the fact that they are not reflected in the published balance sheet or accounts. It will also have further to be accepted that such reserves are kept at the instance of the board of directors of the company. That is so because even by virtue of section 215 of the Companies Act read with section 29(2) of the Banking Regulation Act, the balance sheets have to be signed by the board of directors before they are submitted to the auditors for their report thereon. Sub-section (3) of section 217 of the Companies Act further requires that the board is bound to give the fullest information and explanations in its report made to the general meeting on every reservation, qualification or adverse remarks contained in the auditors'' report. The auditor has further to make his report after inspecting each and every document, and under the Companies Act he has a right of access at all times to the books and accounts and vouchers of the company as per the provisions of section 227 of the Companies Act. The auditor''s report made after inspecting the accounts of the company has to state that he has obtained all the information and explanations which were necessary for the purposes of his audit and that in his opinion proper books of account have been maintained and further that the company''s balance sheet and profit and loss accounts are in all agreement with the books of account. As has been stated earlier, although the secret reserves do not find a place in the published balance sheet and profit and loss account, and the balance sheet and the profit and loss account which he prepares are only a summary of the said books of account, and in view of the further fact that he has to certify that this summary is in accordance with and reflects truly and faithfully the books of account of the company, it will have to be held that the balance sheet and the profit and loss account as published is a true and 1 genuine summary of the financial position of the company and that it will have to be taken as such, and it will not be permissible to go behind it.
It is true that the final authority for the conduct of the affairs of a company lies with the members or shareholders of the company. However, it does not mean that they have unrestricted rights in all matters relating to the affairs of the company. Their authority can be restricted or circumscribed by an express provision made in that behalf under the memorandum and articles of association. There is no common law right to inspect the company''s accounting records or to have a say in the allocation of funds to any particular account. As has been stated in Pednington''s Company Law, 4th edition, p. 617, members of a company have no- statutory or common law right to inspect the company''s accounting records, and they enjoy such right only if it is given by the articles of association, which is rare. There is no dispute that the articles of association of the assessee do not give any such right to its shareholders. On the other hand, regulation 95 of Table A of Schedule I to the Companies Act empowers the board of directors of the company to determine from time to time whether and to what extent and at what times and places and under what conditions or regulations, the accounts and books of the company, or any of them, shall be open for inspection of the members who are not directors. Sub-clause (2) of the said regulation further lays down that no member (not being a director) shall have any right of inspecting any account or book or document of the company, except as conferred by law or authorised by the board or by the company in general meetings. Therefore, it is correct to say that the authority to allocate funds to different accounts does not necessarily vest in the shareholders of the company unless there is an express provision for the same. As far as the present case is concerned, article 109(19) of the articles of association of the assessee-company gives a power to the directors of the company which reads as follows:
Before recommending any dividend, to set aside out of the profits of the company, such sums as they think proper as a reserve fund to meet contingencies, or for equalising dividends, or for special dividends, or for repairing, improving, and maintaining any of the property of the company and for such other purposes as the directors shall in their absolute discretion think conducive to the interests of the company; and to invest the several sums so set aside upon such investments (other than shares of the company) as they may think fit, and from time to lime to deal with and very such investments, and dispose of all or any part thereof for the benefit of the company and to divide the reserve fund into such special funds as they think fit with full power to employ the assets constituting the reserve fund in the business of the company, and that without being bound to keep the same separate from the other assets.
In the present case, therefore, reading the provisions of the said article 109(19) of the articles of association together with the provisions of section 29 of the Banking Regulation Act and section 215 of the Companies Act relating to the signing of the balance sheet and the profit and loss account, the position which emerges is that it is the board of directors who have authority to allocate funds to the reserve account. It is not disputed that the balance sheet and the profit and loss account of the assessee has been signed by the board of directors. Therefore, the position which is reflected in the balance sheet and the profit and loss account, which reflection includes the hidden or secret reserves, will be deemed to have been at the instant of the requisite authority.
The question whether these reserves are ascertainable or not need not cloud the fact that the secret reserves do exist and that they do so at the instance of the requisite authority. In fact, the existence of the secret reserves and its quantum has not been disputed at any stage. The ITO as well as the AAC have proceeded on the basis that a definite amount of Rs. 76,58,687 is maintained by the assessee-company as secret reserve. Even otherwise, as has been observed in Johnston & Jager''s Company Accounting, 2nd edition, p. 396, significant information can be derived from an intelligent reading of the accounts as they stand, particularly if comparative figures are available in the balance sheet, and among the information which may be derived by such intelligent reading, is one relating to the existence or otherwise of secret reserves. This is apparent if the book value of the assets is shown far below the current market value.
Coming to the balance sheet in question, item 4 in the balance sheet is an entry under the head "Investments at below market value". The working of the heading of the said item is itself eloquent and an intelligent reader can at once gather from the said entry that the said investments have been valued at below the market value for the obvious purpose of creating secret reserves. As has been pointed out earlier, in the books of account the mode by which the said figure of Rs. 76,58,687 has been shown to have been arrived at is by working out the difference between the market value of the securities and shares which is shown as Rs. 23,00,71,555.37 and the below market value of the investments which is shown as Rs. 22,24,12,868.18 (which is the figure which is shown as the total value of the items mentioned in the said item 4). The figure of Rs. 76,58,687.19 is shown in the books of account as standing to the credit of the account which is called the premium and discount account. This figure as stated earlier reflects the balance after the sale of shares and securities. It is because the assessee-company has stated the amount standing to the credit of the said account, that the company is impelled to show the value of its total investments in securities and shares less by the said amount. That is the purpose and the role which this amount, which is otherwise called secret reserves, serves in the balance of the accounts of the company as reflected in the published balance sheets and the profit and loss accounts.
Thus, it is more than clear firstly, that the amount is appropriated for the said reserve account by a deliberate action, and, secondly, it is so done by the power of the board of directors which is the requisite authority under the articles of association of the company. Both the conditions laid down by the Supreme Court in Century Spinning''s case (supra), for appropriation of funds to the reserve accounts, are, therefore, fully satisfied in the present case. The said amount will, therefore, be entitled to be called "reserves" notwithstanding that it is not in so many figures reflected in the profit and loss account or the published balance sheet. Hence, it will have to be counted in the capital base of the company for the purpose of rule 1 of the Second Schedule to the Act. In the result, our answer to the first question is in the affirmative and in favour of the assessee. In view of the fact that Question Nos. 2 and 3 do not survive, the same are not answered. The revenue to pay the costs of the assessee.