Commissioner of Income Tax vs Indian Steel Rolling Mills Ltd.

Ramanujam, J.—The assessee is a public limited company. Its accounts for the year ending on 31st March, 1962, relevant for the

assessment year 1962-63, were considered by the board of directors on 19th July, 1962. The profit in that year amounted to Rs. 12,39,139.

After making certain provisions towards tax, gratuity, etc., there was a balance of Rs. 5,88,365. The board of directors recommended the

following appropriations:

Rs.

Transfer to development rebate reserve : 55,000

Proposed dividend :

Preference 35,746

Ordinary 4,87,858

5,78,604

This left a balance of Rs. 9,760. The provisions made towards tax liability and actual payments of tax were as under :

Rs.

Provision as on 1-4-1961 4,00,000

Provision made during the year 4,30,000

8,30,000

Less : Advance tax for 1962-63 1,08,507

Provisional tax paid for 1961-62 3,93,851

5,02,358

The provision for taxation as on March 31, 1961, was Rs. 2,91,493 as against the actual tax liability for 1961-62 of Rs. 2,85,343 leaving a

surplus of Rs. 6,150. The appropriations towards gratuity were as under :

Rs.

Provision for gratuity as on 1-4-1961 2,20,181

Addition during the year 22,178

2,42,359

Less : Payments during the year 9,765

2,32,594

In working out the capital base for the purpose of ascertaining the amount of standard deduction under the Super Profits Tax Act, 1963, the

assessee included the following sums apart from the capital of Rs. 53,82,682 :

Rs.

Development rebate reserve 1,30,950

General reserves 33,104

Repairs and renewal reserve 1,55,174

Balance in the profit and loss account 9,761

Provision for taxation 3,27,643

Proposed dividend 5,23,604

Reserve for gratuity 2,32,595

The Super Profits Tax Officer considered the development rebate reserve and the general reserve as capital and rejected the claim in respect of

the other items for the reason that they were merely provisions for specific liabilities and would not constitute reserves under Rule 1 of the Second

Schedule to the Super Profits Tax Act, 1963.

The assessee appealed to the Appellate Assistant Commissioner. He held that the sum of Rs. 1,55,174 representing the reserve for repairs and

renewals should be regarded as reserve and included it in the computation of capital. He, however, agreed with the Super Profits Tax Officer in

respect of the other items.

On further appeal to the Tribunal, it held that the assessee was entitled to treat the sum of Rs. 2,32,595 representing the provision for gratuity as

a reserve. It also held that the excess provision for taxation in 1961-62 to the extent of Rs. 6,150 would also be a reserve.

At the instance of the revenue, the following questions have been referred to this court u/s 19(1) of the Super Profits Tax Act, 1963:

""Whether, on the facts and in the circumstances of the case, the sum of Rs. 2,32,595 represented reserves as contemplated under Rule 1 of the

Second Schedule to the Super Profits Tax Act, 1963 ?

Whether, on the facts and in the circumstances of the case, the sum of Rs. 6,150 was not part of reserve under Rule 1 of the Second Schedule

to the Super Profits Tax Act, 1963 ?

It is necessary at this stage to refer to the relevant provisions of the Super Profits Tax Act, 1963. Section 4 levies a tax called ""super profits tax

on every company for every assessment year commencing on and from 1st day of April, 1963, 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 ""chargeable profits"" as

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 ""standard deduction"" as meaning an amount equal to 6% 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 greater. Schedule 1 sets out the rules for

computing the chargeable profits. Rule 1 provides that the income, profits and gains under certain heads shall be excluded from the total income

computed under the Income Tax Act for the year while computing the chargeable profits of a previous year. The Second Schedule sets out the

rules for computing the capital of a company for the purpose of super profits tax. Rule 1 of that Schedule which comes up for consideration in this

case 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 (11 of 1922), or under Sub-section (3) of Section 34 of the Income Tax Act,

1961 (43 of 1961), and of its other reserves in so far 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 (11 of 1922), or the Income Tax Act, 1961 (43 of 1961), diminished by the amount by

which the cost to it of the assets the income from which in accordance with Clause (iii) or Clause (vi) or Clause (vii) of Rule 1 of the First Schedule

is not includible in its chargeable profits, exceeds the aggregate of:

(i) any money borrowed by it which remains outstanding ;

(ii) the amount of any fund, any surplus and any such reserve as is not to be taken into account in computing the capital under this rule.

Explanation 1.--A paid up share capital or reserve brought into existence by creating or increasing (by re-valuation or otherwise) any book asset is

not capital for computing the capital of a company for the purposes of this Act.

Explanation 2.--Any premium received in cash by the company on the issue of its shares standing to the credit of the share premium account shall

be regarded as forming part of its paid up share capital.

Explanation 3.--Where a company has different previous years in respect of its income, profits and gains, the computation of capital under Rule 1

and Rule 2 of this Schedule shall be made with reference to the previous year which commenced first.

The object of the said Act is to levy a tax on the excess of the profits over the 6% of the capital which the companies are allowed to distribute

out of their profits as dividend to shareholders which is regarded as super profits. The tax has to be charged on the amount by which the

chargeable profits exceed the amount of standard deduction which is defined in Section 2(9) of the Act. A minimum standard deduction of Rs.

50,000 is prescribed with the object of excluding small companies whose income does not exceed that sum from the operation of the Act. Under

Rule 1 of Schedule 2, capital means the paid up share capital and includes reserves, if any, created u/s 10(2)(vib) of the Indian Income Tax Act,

1922, or Section 34(3) of the Income Tax Act, 1961, which is normally referred to as ""development rebate reserve"" and other reserves which

have not been allowed in computing the profits of the company for the purpose of Income Tax. In this case, we are concerned with the question as

to what are the ""other reserves"" referred to in Rule 1 of Schedule 2.

According to the revenue, the word ""reserves"" occurring in Rule 1 of the Second Schedule has to be understood in a restrictive sense and as

distinguished from a provision or liability, and that only amounts set apart as reserve for use in the business would come under the word ""reserve

occurring in the said rule. What in effect the revenue contends is that it is only capitalised or tied up reserves that are contemplated by the rule and

not all the amounts shown as reserves in the profit and loss account, irrespective of their nature. But, according to the assessee, the expression

other reserves"" occurring in Rule 1 will include any reserve not allowed in the computation of profits under the Income Tax Act, apart from the

development reserve which is an allowable item under the Income Tax Act, and, therefore, the reserve need not be a tied up reserve, and a mere

reserve or a provision will come under the word ""reserve"".

The Supreme Court in Commissioner of Income Tax, Bombay City Vs. The Century Spinning and Manufacturing Co. Ltd., considered a

somewhat similar provision in Rule 2(1) of Schedule 2 to the Business Profits Tax Act, 1947, which read :

Where the company is one to which Clause (a) of Rule 3 of Schedule I applies, its capital shall be the sum of the amounts of its paid-up share

capital and of its reserves in so far as they have not been allowed in computing the profits of the company for the purposes of the Indian income tax

Act...

Their Lordships of the Supreme Court observed, after referring to the various dictionary meanings of the word ""reserve"", that the item

reserve"" is not defined in that Act, that, therefore, it must be given the ordinary natural meaning as understood in common parlance and that the

word ""reserve"" in the sense in which it is used in the said rule can only mean profit earned by a company and not distributed as dividend to the

shareholders but kept back by the directors for any purpose to which it may be put in future. This test was applied by the Supreme Court in First

National City Bank Ltd. v. Commissioner of Income Tax, : [1961]42ITR17(SC) and again in The Commissioner of Income Tax (Central),

Calcutta Vs. Standard Vacuum Oil Company, , where it reaffirmed its view that in its ordinary meaning the expression ""reserve"" means something

specifically kept apart for future use or for a specific occasion.

In Commissioner of Income Tax and Business Profits Tax, Madras Vs. Vasantha Mills Limited, , this court upheld an assessee''s claim for a

sum of Rs. 9 lakhs shown as provision made for the relevant year of account for payment of Income Tax and excess profits tax as reserve for the

purpose of Rule 2(1) of Schedule 2 to the Business Profits Tax Act, 1947, holding that the said sum was set apart for a specific purpose with a

specified end in view and that the reservation of a specified sum for a specified use by a person authorised to do so would bring the sura so

reserved within the meaning of the expression ""reserve"" in Rule 2(1). What constitutes a reserve under Rule 2(1) of the said Schedule was also

considered by the Calcutta High Court in Indian Steel and Wire Products Ltd. Vs. Commissioner of Income Tax, West Bengal, Calcutta,

We are concerned in this case with the nature of a reserve. If I may refer to the definition given in Murray''s Oxford Dictionary, to which the

Supreme Court also referred, but only to give the various meanings of the word ''reserve'' as a verb, the meaning as a noun is given as follows;

''Something stored up, kept back, or relied upon, for future use or advantage ; a store or stock.''

An illustration of such use of the word ''reserve'' is drawn from Political Economy by Rogers and the following sentence is quoted :

''It is a maxim in business that a man . . . should have a hoard or reserve from which he can draw, when the times are untoward.''

Apart from the dictionary meaning of the word ''reserve'', I think it can hardly be disputed that nothing can be reserved unless it has been reserved

or laid by or stored for use or application in a future contingency which is anticipated as certain or likely. In the actual administration of companies

also a part of the surplus profits is removed from the immediate business of the company by way of a provision against future contingencies and a

reserve is thus created, although after being carried to the reserve, the amount in question may be invested or re- employed in the business, if the

articles so permit.

In Aluminium Industries Ltd. Vs. Commissioner of Income Tax, the Kerala High Court came to consider the meaning of the expression

reserve"" in Rule 1 of the Second Schedule to the Super Profits Tax Act, 1963, with which we are concerned. The court applied the test

propounded by the Supreme Court in Century Spinning and Manufacturing Cos. case holding that the considerations governing the question under

the Super Profits Tax Act, 1963, were substantially the same as those under the Business Profits Tax Act, 1947, that in order to constitute a

reserve, there must be a clear intention to show that it was either a general reserve or a specific reserve but that a mass of undistributed profits is

not a reserve even though it is shown in the balance-sheet as a reserve: The decisions referred to above indicate that the term ""reserve"" means a

sum specifically set apart for future use or for a specific occasion before the distribution of dividends to the shareholders and that it must be a

specified sum for a specified use.

In this case, we are concerned with two items, that is, Rs. 2,32,595, shown as reserve for gratuity and Rs. 6,150 being the excess provision

for tax. As regards the amount set apart for payment of gratuity to employees, it is seen that the payment of gratuity is governed by a scheme which

provided that every permanent employee of the assessee-company would be eligible for a retiring gratuity which would be equal to half a months''

salary or wages for every completed year or continuous service put in since 1st January, 1941, subject to a maximum of 15 months'' salary or

wages in all. It also provided that the retiring gratuity would be based on the rate of salary or wages applicable to the employee in the last month of

the active service or if the employees had retired while on leave in the last month prior to the employee going on leave. We are of the view that the

amount set apart for payment of gratuity to the employees under such a scheme should be taken as a reserve. It is not in dispute that the company

is under a liability to pay gratuity to its employees as per the scheme referred to above. To meet such an indefinite and unascertainable liability, a

reserve has been created by the assessee and sums have been set apart, and added to it out of the profits earned every year. The sum so set apart

has been used by the company for its business. The sum set apart for gratuity really represents the assesee''s own funds in the form of reserve. It is

pointed out by the learned counsel for the revenue that the sum is shown in the balance-sheet under current liabilities and provisions and, therefore

it cannot be taken to be a reserve. It is pointed out that Schedule 6 to the Companies Act makes a clear distinction between current liabilities and

provisions on the one hand and reserves and surplus on the other, and that, therefore, the assessee itself should be taken to have treated this sum

as a current liability or a provision. But we do not think that the manner in which the balance-sheet has been prepared will decide the question as to

whether the amount is really a reserve or not for the purpose of the Super Profits Tax Act.

In Standard Mills Co. Ltd. Vs. Commissioner of Wealth-tax, Bombay City, the Supreme Court considered the question as to whether the

liability for gratuity to employees under industrial awards is deductible as a debt owed on the valuation date under the Wealth-tax Act, 1957, and it

held that the liability of the assessee to pay gratuity to its employees on determination of employment was a mere contingent liability which arose

only when the employment of the employee was determined by death, incapacity, retirement or resignation, that such a liability did not exist in

praesenti and, therefore, could not be deducted as a debt in computing the net wealth of the assessee, nor can such a contingent and future liability

be taken into account for computing the assets of the assessee u/s 7(2)(a) of the Wealth-tax Act, 1957. In Commissioner of Income Tax v.

Standard Vacuum Oil Co., the Supreme Court dealt with a case where amounts had been set apart as ""earned surplus"". This sum did not merge

into the account of the subsequent year. It represented a specific account into which were added the net profits of the year and appropriations

were made out of it and the balance was regarded as ""earned surplus"" at the end of the year. This account was specifically allocated for utilisation

for the purpose of business year after year. It was an account in which the net profits less the appropriations were added, and the account was

intended for application in extending the business of the assessee-company. The court held that the said ""earned surplus"" should not be regarded as

mere unallocated profits and as it represents amount set apart for the purposes of the business of the company at the end of the accounting year, it

constituted a reserve.

Having regard to the principle laid down in these cases, we are of the view that the amounts set apart for payment of gratuity, a contingent and

future liability and which have been used for the purpose of the business of the company, should be treated as a reserve. We are not inclined to

agree with the contention of the revenue that the ""reserve"" contemplated by Rule 1 of Schedule 2 should be a capitalised or a tied up reserve. In

our view, the reserve contemplated by that rule need not be a capitalised or tied up reserve. The Kerala High Court in Commissioner of Income

Tax Vs. Periakaramalai Tea and Produce Co. Ltd., has taken the same view. It held that the amount set apart for gratuity payments is a reserve

and its reasoning is this:

It appears to us in the light of what has been said by the Supreme Court in the decisions to which we have adverted that a reserve is any sum of

money which has been kept back for future use whether the purpose for which it is so kept back be general or specific. Naturally, therefore, there

is nothing strange if some specific purpose is indicated in the reservation, since reserve for a specific purpose is as much a reserve as for a general

purpose. The reservation in regard to payments to be made on account of liabilities which have already arisen cannot be properly termed

''reserves'' in the above sense. Equally so, it cannot be said that reserves made for specific purposes though not to meet liabilities which have

already arisen but as a prudent provision for a future liability which may arise are not reserves but are only provisions to meet liabilities. It is not

disputed that the reservation in the present case is not for any commitment which has already arisen or payment of which has fallen due but is only

a provision in regard to gratuity which may have to be paid to the employees as and when the liability may arise in future.

Next we come to the excess provision made for taxes. According to the assessee an excess or overshot provision is to be treated necessarily

as a reserve, for the sum set apart is used for the business of the assessee and reference is also invited to the Circular No. 2-P(XV-6) dated 5th

February, 1968, of the Central Board of Revenue which treats an excess provision as a reserve. That circular directs that an excess provision in

the development rebate reserve account over and above the minimum statutory percentage should be taken to come under the words ""other

reserves"" occurring in Rule 1 of Schedule 2. In Commissioner of Income Tax Vs. Security Printers of India (P.) Ltd., , the term ""reserve"" in Rule 1

of the Second Schedule to the Super Profits Tax Act was construed as a sum specifically kept apart for future use or application in a future

contingency which is anticipated and provisions made for bonus, for taxation and for proposed dividends by a company were treated as

reserves"". In this case the question is limited as the assessee has claimed only the excess provision for tax as a reserve. We are definitely of the

view that the sum of Rs. 6,150 which is an excess provision for taxation and which was available for use by the company in its business has rightly

been treated as a ""reserve"".

The learned counsel for the revenue points out that there is a clear-cut distinction between a reserve and a provision and that a mere provision

to meet a future contingency cannot be treated as a reserve at all and that the words ""other reserves"" should be read ejusdem generis with the

development rebate reserve. Though there is a distinction between a reserve and a provision in the Companies Act; that distinction cannot be

imported into the meaning of the word ""reserve"" in Rule 1 of Schedule 2. In this rule the word ""reserve"" has to be understood as a specified

amount set apart for a specific purpose by a company, before distribution of dividends, which is available for future use of the company. That test

is fully satisfied in this case. Therefore, the amounts set apart for gratuity and the excess provision for tax have to be treated as ""reserves"". Both the

questions are, therefore, answered in favour of the assessee. The assessee will have its costs from the revenue. Counsel''s fee Rs. 250.