Commissioner of Income Tax vs Dey''s Medical Stores Ltd.

Sen, J.—The following question of law has been referred to this Court by the Tribunal u/s 256(1) of the income tax Act, 1961 (''the Act''):

"Whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that the ''contingency reserve'' was not created for a specific purpose and, in that view was correct in holding that the balance in the ''contingency reserve'' should be taken in computing the capital base of the company in terms of rule 1 (iii) of the Second Schedule of the Surtax Act, 1964 ?"

The facts, as narrated by the Tribunal in the statement of case, are as under:

The ITO who completed the assessment for the assessment year 1978-79 noted in the order that the assessee claimed contingency reserve of Rs. 3,64,679 as reserve to be taken as the computation base. This reserve was created by the transfer of the amount from their profit and loss appropriation account. The ITO noted that although there was no explanation in the auditor''s note, the assessee submitted that the reserve was created to make subsequent bonus payment if fell short. The claim was made under rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964 (''the Surtax Act'') under the category ''other reserve''. The ITO pointed out that reserve has been differentiated from provision although there was no definition given in the Act. In the instant case, he pointed out that the reserve was created towards a known liability but the quantum was unascertained and the payment had been made out of it in the relevant year and in the following years also and, therefore, it could not be said that there was a reserve created to strengthen the capital base. He pointed out that it was nothing but a provision for bonus reserve. The claim of the assessee was accordingly rejected. That was in the assessment year 1978-79.

In the assessment year.1979-80, the ITO disallowed the claim on the same basis in respect of the amount which was stated to be Rs. 3,89,699. In the assessment year 1980-81 the similar claim was made for Rs. 3,79,285. The ITO on the basis of his earlier order declined to accept the contention of the assessee.

The assessee took up the matter before the Commissioner (Appeals) who allowed the claim of the assessee. The assessee pointed out that the contingency reserve was created for the first time for the year 1978-79 after appropriating from surplus of profit and loss account and general reserve. It was pointed out that in the balance sheet, the contingency reserve was shown under the general head ''Reserve and surplus''. The assessee relied on the decision of the Hon''ble Calcutta High Court in the case of Dunlop India Ltd. Vs. Commissioner of Income Tax, . In the case of the present assessee the contingency reserve was not earmarked for any specific purpose. The Commissioner (Appeals) directed the ITO to include the above sum in the capital base for the purpose of the Surtax Act.

The department preferred an appeal before the Tribunal. The Tribunal noted the facts of the case that some time prior to the accounting period corresponding to the assessment year 1978-79, the assessee created a reserve known as ''contingency reserve'' account and the balance standing at the credit of this account was Rs. 3,64,579 during the accounting period corresponding to the assessment year 1978-79, and that a further sum of Rs. 25,120 was transferred to the aforesaid reserve so that the balance at the end of the accounting period in the said account stood at Rs. 3,89,699. For the assessment year 1979-80 a further sum of Rs. 10,414 was added. No further addition was made to the reserve account so that the balance at the end of the accounting period in this account stood at Rs. 3,79,285. For the assessment year 1980-81 a reserve of Rs. 92,892 was created and simultaneously a sum of Rs. 1,19,923 was transferred to the profit and loss appropriation account out of this amount so that the balance at the end of the accounting period in this account stood at Rs. 3,52,254. The assessee claimed that the balance standing at the beginning of the accounting period of the respective assessment years should be taken into account for working out the capital base. The assessee relied on the ratio of the decision of the Calcutta High Court in the case of Dunlop India Ltd. (supra).

The revenue, on the other hand, contended that the reserve in question was created for the specific purpose of meeting the shortfall in the amount of bonus and, therefore, it could not be classified as a reserve and that it was for a specific purpose and, therefore, it was a provision.

The Tribunal considered the different aspects of the matter and found that the ITO''s view on the face of it, was not correct. It was also observed that the stated purpose was to provide for a shortfall in the bonus in future, if any, which apparently was not to pay bonus out of it but to transfer some unspecified amount as and when necessary to make up shortfall in the provision for bonus by the assessee-company. The Tribunal observed that it was wrong to say that keeping a part of the profit for the aforesaid purpose was to meet the known liability. It was also pointed out that the company could not foresee as to when there would be surplus in the provision for bonus account or when there would be shortfall in the said account and the creation of the contingency reserve account to even out such shortfall if it ever occurred, was not for payment of bonus as such but for transferring the amount from the aforesaid reserve account to the profit and loss appropriation account. The Tribunal, therefore, concluded that as such the amount could not be regarded as ''provision''. It was clearly in the nature of a ''reserve'' and, therefore, the claim of the assessee was sustained.

Mr. Bagchi, appearing for the department, has firstly contended that no reserve was actually created by the assessee and, therefore, there cannot be any question that his account in controversy can be treated as reserve. This argument was not advanced either before the AAC or before the Tribunal. The ITO has also not stated in its order that the no reserve was made. On the controversy the ITO has observed in the instant case that reserve was created towards a known liability but the quantum was ''unascertained''. The creation of the reserve was not in dispute at any stage. Therefore, this argument is entirely misconceived and is not borne out by the facts on record.

The second contention of Mr. Bagchi is that the reserve was created for a liability that was known to the assessee because the purpose was to make payment of bonus out of the reserve fund.

Reliance was placed on the judgment of the Supreme Court in the case of Vazir Sultan Tobacco Co. Ltd., Hyderabad and Others Vs. Commissioner of Income Tax, Andhra Pradesh, Hyderabad, , where the difference between the expressions ''provision'' and ''reserve'' was explained. It was held that a provision was a charge against the profits to be taken into account against the gross receipts in the profit and loss account, while a ''reserve'' was an appropriation out of the profits, the asset or assets by which it was represented, being retained to form part of the capital employed in the business. It was also observed in that case that the question whether an amount constitutes ''reserve'' or not will have to be found out, having regard to the true nature and character of the sums so appropriated and for that the appropriation must be determined with reference to the substance of the matter and for that one must have regard to the intention for the purpose of which appropriation has been made and such intention and purpose had to be gathered from the surrounding circumstances.

The second case on which reliance was placed was the decision of the Supreme Court in the case of CIT v. Elgin Mills Ltd. [1986] 161 ITR 733 1 where it was held that in computing the capital to determine the ''statutory deduction'' for the purpose of surtax under the Surtax Act, (i) investment reserve, (ii) rehabilitation reserve, (iii) capital reserve, and (iv) depreciation reserve were to be treated as reserves but the amount of ''forfeited reserve'' could not be treated as a ''reserve''. It was reiterated in that judgment that ''reserve'' was an appropriation of profit to provide for the asset which it represented.

Mr. Bagchi drew our attention to the following passage where after referring to a decision of the Calcutta High Court in the case of Commissioner of Income Tax and Super Profits Tax Vs. Eyre Smelting Pvt. Ltd., ; the Supreme Court observed :

"...It held, inter alia, that provisions were made against anticipated losses and contingencies, and it held further that an amount set aside out of the profits, designed to meet a contingency or liability or commitment or diminution in the value of assets known to exist would be a reserve, and an amount set aside to provide for a known liability of which the amount cannot be determined with substantial accuracy would be a provision...." (p. 739)

It was the contention of Mr. Bagchi that these observations went against the contention of the assessee that contingent liability could be treated as a reserve.

It is clear from the aforesaid judgments of the Supreme Court that whether the contingency reserve was a reserve or provision will depend upon the purpose and intention of the assessee for creating such a reserve. If it is to meet a contingency, which is unforeseen and cannot be anticipated, then the amount so set apart as reserve cannot be treated as a provision to meet a known liability. In the instant case, the finding of the Tribunal is that the amount has not been set apart for payment of bonus but the reserve was created to meet an unknown and unforeseen eventuality. This is a case of an amount being set apart to meet an unknown liability which may not arise at all. The assessee as a prudent businessman set apart a certain sum of money to meet an unknown contingency.

In view of the principles laid down by the Supreme Court, this amount is to be treated as a reserve and not provision.

The Tribunal has specifically found that the liability for payment of bonus had been separately provided for by the assessee-company every year. This reserve had not been created for meeting an existing or known liability to pay bonus. An amount was set apart as a prudent businessman to provide for an unknown contingency.

In that view of the matter, the question is answered in the affirmative and in favour of the assessee. There will be no order as to costs.

Banerjee, J.

I agree.