Commissioner of Income Tax vs Malayala Manorama Co. Ltd.

Arijit Pasayat, C.J.—Pursuant to the direction given by this court in O.P. No. 11720 of 1992 u/s 256(2) of the Income Tax Act, 1961 (in short "the Act"), the following question has been referred to this court for opinion by the Income Tax Appellate Tribunal, Cochin Bench (in short "the Tribunal"):

"Whether, on the facts and in the circumstances of the case, the capital redemption reserve forms part of the capital for purpose of surtax ?"

The factual position as indicated in the statement of case is as follows : The assessee, a public limited company, admitted a chargeable profit of Rs. 8,22,586. While computing the statutory deduction of capital, a sum of Rs. 3 lakhs as "capital redemption reserve" was included. This was excluded by the Assessing Officer. The Commissioner of Income Tax (Appeals) (in short "the CIT (Appeals)") allowed the deduction. In appeal, the Tribunal, following its earlier order in the assessee''s case in STA Nos. 9 and 10/Coch. of 1986, accepted the assessee''s stand and held that a general reserve by definition is a reserve, unlike a provision and therefore it has to form part of the capital of the company for the purpose of surtax.

In support of the reference application, Mr. P.K.R. Menon, counsel appearing for the Revenue, submitted that the matter stands closed in view of the apex court''s decision in National Rayon Corporation Ltd. etc. Vs. Commissioner of Income Tax, , where it was observed that the debenture redemption reserve was not includible in capital, as the amount was not in the nature of a reserve. Shri M. Pathrose Mathai, learned counsel for the assessee, submitted that the position is different in the case of "capital redemption reserve" and the aforesaid decision has no application.

The conceptual difference between "reserve" and "provision" can be noted as follows. According to the dictionaries (both Oxford and Webster), the applicable primary meaning of the word "reserve" is : "to keep for future use or enjoyment; to set apart for some purpose or end in view ; to keep, in store for future or special use" : "to keep in reserve", while "provision" according to Webster means : "something provided for future". In other words, according to the dictionary meanings, both the words are more or less synonymous and connote the same idea. Since the rules for computation of capital contained in the Second Schedule to the Act proceed on the basis of the formula of capital plus reserves--a formula well known in commercial accountancy, it becomes essential to know the exact connotation of the two concepts "reserve" and "provision" and the distinction between the two as known in commercial accountancy. A reserve is a standby created out of profits of a business to meet contingencies which are unknown and which cannot be foretold on the basis of knowledge of current facts. It is created by way of appropriation of profits. It is not a charge against profits. Since it is an appropriation, it does not go out of the business, but is retained in the business as a part of the capital. But a provision is a charge against profits. It is created to meet liabilities, which are known and foreseeable but whose exact timing, and hence whose quantification alone, are uncertain, at the moment.

As stated by William Pickles in the book Accountancy (third edition at page 184) : "A provision is an amount set aside out of profits and other surpluses provided for .... diminution in the value of assets or any known liability of which the amount cannot be determined with substantial accuracy." According to Clause 7(1)(a) of Part III of Schedule VI to the Companies Act, 1956, "provision" means "any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy". The characteristics of a provision are : (a) provisions are made against anticipated losses and contingencies, (b) provisions are charges against profits, (c) provisions are taken into account in the profit and loss account against gross receipts ; (d) an amount set aside out of profits designed to meet a liability or contingency or commitment or diminution in the value of assets known to exist at the date of the balance-sheet can be a provision ; (e) an amount set aside to provide for any known liability of which the amount cannot be determined with substantial accuracy is a provision ; (f) provisions are usually shown in the balance-sheet by way of a deduction from the assets in respect of which they are made (see Metal Box Co. of India Ltd. v. Their Workmen [1969] 73 ITR 55. A "reserve" according to Clause 7(1)(b) of Part III of Schedule VI to the Companies Act shall not include any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets or retained by way of providing for any known liability. The characteristics of a "reserve" are ; (a) reserves are appropriations of profits, the assets by which they are represented being retained to form part of the capital employed in the business ; (b) reserves are not designed to meet any liability, contingency, commitment or diminution in the value of assets known to exist at the date of the balance-sheet; (c) reserves are something set apart for future use or enjoyment ; (d) general reserves and reserve funds are shown as part of the owners'' interest.

Besides, though the expression "reserve" is not defined in the Act, it cannot be forgotten that it occurs in a taxing statute which is applicable to companies only and to no other assessable entities and as such the expression will have to be understood in its ordinary popular sense, that is to say the sense or meaning that is attributed to it by men of business, trade and commerce and by persons interested in or dealing with companies. Therefore, the meanings attached to these two words in the provisions of the Companies Act, 1956, dealing with preparation of balance-sheet and profit and loss account would govern their construction for the purposes of the two taxing enactments. Though the term "provision" is defined positively by specifying what it means, the definition of "reserve" is negative in form and not exhaustive in the sense that it only specifies certain amounts which are not to be included in the term "reserve". In other words, the effect of reading the two definitions together is that if any retention or appropriation of a sum falls within the definition of "provision" it can never be a reserve but it does not follow that if the retention or appropriation is not a provision it is 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 purpose for which such retention or appropriation has been made because the substance of the matter is to be regarded and in this context the primary dictionary meaning of the term "reserve" may have to be availed of. But it is clear beyond doubt that if any retention or appropriation of a sum is not a provision, that is to say, if it is not designated to meet depreciation, renewals or diminution in value of assets or any known liability, the same is not necessarily a reserve. The question whether the concerned amounts in fact constituted "reserves" or not will have to be decided by having regard to the true nature and character of the sums so appropriated depending on the surrounding circumstances particularly the intention with which and the purpose for which such appropriations had been made.

In Commissioner of Income Tax Vs. Vazir Sultan Tobacco Co. Ltd., , the position was illuminatingly stated by the court as follows (page 570) :

"Schedule VI to the Companies Act prescribes the form in which the balance-sheet shall be prepared by a company. The pro forma contains separate columns for liabilities and assets. Under the heading ''reserves and surplus'' in the column ''liabilities'', seven types of reserves/funds are mentioned. Among them ''capital redemption reserve'' is No. 2. This clearly shows that capital redemption reserve is a ''reserve''. Now, the Explanation to Rule 1 says that any amount standing to the credit of any account in the books of the company, which is in the nature of items No. 5, 6 or 7 under the heading ''reserves and surplus'' in the column relating to ''liabilities'' in the aforesaid pro forma, shall not be regarded as ''reserve'' for the purposes of computation of the capital base of the company. This would, by necessary implication, mean that ''capital redemption reserve'' is one of the reserves to be taken into account for computing the capital base.

In this connection, Section 80 of the Companies Act may also be referred to. Section 80 deals with the power of the company to issue redeemable preference shares, but certain limitations are placed on such power. The limitations are that no such shares shall be redeemed except out of profits of the company which would otherwise be available for dividend or out of the proceeds of a fresh issue of shares made for the purposes of the redemption. It is further provided that where such shares are redeemed otherwise than out of the proceeds of a fresh issue, there shall, out of profits which would otherwise have been available for dividend, be transferred to a reserve fund, to be called the ''capital redeemption reserve account'', a sum equal to the nominal amount of the shares redeemed ; and the provisions of the said Act relating to the reduction of share capital shall apply in that behalf. This provision also gives an indication that ''capital redemption reserve'' partakes of the nature of share capital. For the above reasons, we agree with the Tribunal that the capital redemption reserve should be taken into account while determining the capital base of the company."

In view of the aforesaid position, we are of the view that the decision in National Rayon Corporation Ltd. etc. Vs. Commissioner of Income Tax, , has no application to the facts of the case and the conclusion of the Tribunal is correct. That being the position, the question referred to is answered in the affirmative, in favour of the assessee and against the Revenue.

The reference is accordingly answered.