VAZIR SULTAN TOBACCO CO. LTD. ETC. ETC. v. COMMISSIONER OF INCOME-TAX ANDHRA PRADESH, HYDERABAD

Citation: [1982] 1 S.C.R. 789

Court: Supreme Court of India

Bench: V.D. TULZAPURKAR, E.S. VENKATARAMIAH, AMARENDRA NATH SEN

Case summary

10 of the Super Profits Tax Act at the instance of the assessee company the following question of law was referred to the Andhra Pradesh High Court for its opinion : 34 of the Income Tax Act, 1961, and of its other reserves in so far as the amounts credited r to such other...

Judgment text

VAZIR SULTAN TOBACCO CO. LTD. ETC. ETC. v. COMMISSIONER OF INCOME-TAX ANDHRA PRADESH, HYDERABAD September 250 ! 981 • (V. D. TULZAPURKAR, E. S. VENKATARAMIAH AND AMARENDRA NATH SEN, JJ. ] Super Profits Tax Act, 1963 and Company's (Profits) Sur-tax Act, 1964- Ru/e I ofSecond Schedule-Scope of-''Provision" and "Reserve"·-Distinction- A sum ofmoney transferred from current profits to general reserves-Dividend paid from that fund-General reserve how calculated. The Super (Profits Tax) Act, 1963 and the Company's (Profits) Sur-ta. Act, 1964 (the scheme and main provisions of both of which are almost identical) impose a special tax on excess profits earned by companies.

The special t~ is imposed in respect of so much of a company's "chargeable profits" of the previous year as exceeded the "standard deduction"- The term "chargeable profit" is defined to mean th~ total income of an assessee computed under the Income Tax Act, 1961 for aDy previous year and adjusted in accordance with the provisions of that Act. "Standard deduction" is determined by computing the capital of a company in accordance with the rules laid down in the schedule. The material part of rule 1 provides that before any amount or sum qualifies for inclusion in capital computation of a company two conditions are required to be fulfilled namely : (i) that the amount or sum must be a "reserve" and (b) that it must not have been allowed . in computing the company's profit for the purposes of Income Tax Acts, 1922 or 1961.

In their respective balance sheets, the assessees had shown under the heading "current liabilities and provisions" appropriations of large sums of money for taxation, retirement gratuity and dividends and claimed that for the purposes of 1 ion clearly suggests that the appropriation of the amounts set apart by the assessee companies before us for taxation would constitute a provision made by them to meet a known and existing liability and as such the concerned amounts would not be includible in capital computation. Counsel for the assessee company in Vazir Sultan Tobacco Company's case, however, attempted to raise a further plea that the provision for taxation in the sum of Rs. 33,68,360 was an excess provision in the sense it was in excess of the amount which was 0 reasonably necessary for the purpose of taxation and, there ore, the excess should be treated as a reserve and not a provision and in this behalf reliance was placed on cl.

(7) (2) of Part III of Schedule VI and three decisions-of the Madras High Court Commissioner of 1 Income-tax Madras v. Indian Steel Rolling Mills Ltd. ( ) of the Himachal Pradesh High Court in Hotz Hotels Pvt. Ltd. v. Commissioner of Income Tax, Haryana, H. P. and Delhi(') and of Allahabad High Court in Commissioner of Income-Tax, Delhi v. Modi Spinning and Weaving Mills(').

There could be no dispute about the principle that if provision for a known or existing liability is made in excess of the amount that would be reasonably necessary for the purpose the excess shall have to be treated as a reserve and, therefore, would be includible in the capital computation but no such case was made out by the assessee company at any stage of the assessment proceedings either before the Taxing Authorities or even before the Tribunal or the High Court and in the absence of any such plea having been raised at any stage of the proceedings it will not be proper for this Court to allow the assessee company to raise such plea, which will need investigation into facts, for the first time in its appeal before this Court. The contention is, therefore, rejected. Dealing next with the item of appropriation made for retirement gratuity, which arises only in Civil Appeal No. 860/1973 (Vazi; Sultan Tobacco Co. ) the question is whether the sum of Rs.

9,08, I06 appropriated or set apart by the assessee company from out 01 its profits and other surpluses by way of providing for retirement gratuity is a provision or a reserve on the relevant date, (I) 92 ! TR 78. (2) 101 ! TR 596. (3) 117 ! TR 23. VAZIR SULTAN TABACCO co. v. C. I. T. (Tulzapurkar, J. ) 807 viz. l. I0.! 96!? Counsel for the assessee-company vehemently urged before us that this appropriation had not been allowed as a deduction in the income-tax assessment proceedings of the company for the relevant assessment year on the ground that it was in the nature of a reserve and the entire sum, minus the actual payments, was added back to the income and profits of the assesseecompany and if that be so, in the super profit-tax assessment it cannot be treated as a provision and excluded from capital computation. Accordiag to him there could not be two different treat- • ments for the same item in income·tax assessment and super profittax assessment.

He pointed ant that this contention was specifically urged in the appeal before the Appellate Assistant Commissioner but was wrongly rejected. He further submitted that no actuarial valuation had been undertaken but ad hoc amount was appropriate or transferred to gratuity reserve and as such the same shoe Id have been treated as a reserve and included in capital computation. On the other hand, counsel for the Revenue seriously disputed the last ; submission and contended that it was never the case of the assessee- 0 company either before the Taxing Authorities or before the Tribunal or before the High Court that the appropriation was of an ad hoc sum without undertaking any actuarial valuation.

It must be observed that whereas the assessee-company did urge a contention before the lower authorities that different treatments for the same item could not be given for purpose of income-tax assessment and super profit-tax assessment, the assessee company did not clarify by placing material on record as to whether the appropriation of the amount was based on any actuarial valuation or whether it was an appropriation of an ad hoc amount an aspect which, as we shall presently point out, has a vital bearing on the question whether the appropriation could be treated as a provision or a reserve. In the absence of proper material touching this vital aspect, we are afraid, the issue in question will have to be remanded to the Taxing Authorities through the Tribunal for disposal in the light of the well settled principles in that behalf, which we shall presently indicate.

Ordinarily an appropriation to gratuity reserve will have to be regarded as a provision made for a contingent liability, for, under a scheme framed by a company the liability to pay gratuity to its employees on determination of employment arises only when the employment of the employee is determined by death, incapacity, retirement or resignation-an event (cessation of employment) certain to happen in the service career of every employee; moreover, the amount of gratuity payable is usually dependent on the emp- loyee's wages at the time of determination of ~,jg employment and the number of years of service put in by him and the liability accrues and enhances with completion of every year of service; but the company can work out on an actuarial valuation its estimated liability (i. e. discounted present value of the liability under the scheme on a scientific basis) and make a provision for such liability not all at once but spread over a number of years.

It is clear that if by adopting such scientific method any appropriation is made such appropriation will constitute a provision representing fairly accurately a known and existing liability for the year in question; if, however, an ad hoc sum is appropriated without resorting to any scientific basis such appropriation would also be a provision intended to meet a known liability, though a contingent one, for, the expression 'liability' occurring in cl. (7) (1) (a) of Part III of the Sixth Schedule to the Companies Act includes any expenditure contracted for and arising under a contingent liability; but if the sum so appropriated is shown to be in excess of the sum required to meet the estimated liability (discounted present value on a scientific basis) it is only the excess that will have to be regarded as a reserve under cl. (7) (2) of Part III to the Sixth Schedule.

Jn the above context we might refer to one English case ' decided by the House of Lords and two or three decisions of this Court, which seem to lead to aforesaid propositions. In Southern Railway of Peru Ltd. v. Owen(') an English Company operating a railway in Peru was, under the laws of that country, liable to pay its employees compensation on the termination of their services either by dismissal or by notice or on such termination by death or effiux of contractual time. The compensation so paid was an amount equivalent to one month's salary at the rate in force at the date of determination for every year of service.

In the computation of taxable income under the Income-tax Act 1918, the company claimed to be entitled to charge against each year's receipts the cost of making provision for the retirement payments which would ultimately be thrown on it, calculating the sum required to be paid to each employee if he retired without forfeiture at the close of the year and {j setting aside the aggregate of what was required in so far as the year had contributed to the aggregate. The House of Lords rejected the deductions on the ground that in calculating the deductions the company had ignored the factor of discount. But, their Lordships recognised the principle that the company was entitled to charge, against each year's receipts, the cost of making the (I) [1957] A. C. 334. VAZIR SULTAN TOBACCO v. C.!. T. (Talzapurkar, J.

) 809 provision for the retirement which would ultimately be payable as the company had had the benefit of the employee's services during that year provided the present value of the future payments could be fairly estimated. Lord MacDermott observed at page 345 as follows: " ..... as a general proposition it is, I think right to say that, in computing his taxable profits for a particular year, 8 • a trader, who is under a definite obligation to pay his employees for their services in that year an immediate payment and also a future payment in some subsequent • year, may properly deduct, not only the immediate payment but the present value of the future payment, provided such present value can be satisfactorily determined or fairly estimated. " In Standard Mills Co. Ltd. v. Commissioner of Wealth-Tax, Bombay (') the question for decision was whether an estimated .. !

liability under gratuity schemes framed under industrial awards 0 amounted to 'debts' and could be deducted while computing the net wealth of the assessee-company under the Wealth Tax Act. This Court held in view of the terms of s. 2 (m) of that Act, that as the liability to pay gratuity was not in praesenti but would arise in future on determination of the service, i. e. on the retirement, death or termination, the estimated liability under the schemes would not be 'debt' and, therefore, could not be deducted while computing the net wealth. The House of Lords decision in the case of Southern Rly. of Peru Ltd. (supra) was distinguished by this Court as having no relevance to the question before it on the ground that the House of Lords in that decision was concerned in determining the deductibility of the present value of a liability which may arise in future in the computation of taxable income for the relevant year under the income-tax laws.

It will thus appear that this Court was of the view . that though such a liability is a contingent liability and, therefore, not a 'debt' under s. 2(m) of the Wealth-Tax Act it would be deductible under the Income Tax Act while computing the taxable profits; in other words different considerations would apply to cases arising under the Wealth-Tax Act and the Income-Tax A. ct. In Metal Box Co's case (supra) this Court was concerned with the nature of liability under a scheme of gratuity in the context of the Payment of Bonus Act, 1965 and the question related to a sum (! ) 631. T. R. 470. of Rs. 18. 38 lakhs being the estimated liability under the two gratuity schemes framed by the company, which was deducted from the gross f receipts in the P & L Account, it being contended on behalf of the workmen that such deduction was not justified wbile determining the 'available surplus' and the 'allocable surplus' for payment of bonus to them under the Payment of Bonus Act, 1965.

The Court rejected the contention and adverting to the decision of House of Lords in • the case of Southern Rly. ofPeru Ltd. (supra) held that an estimated liability under gratuity schemes even if it amounted to a contingent liability and was not a 'debt' under the Wealth Tax Act, if properly ascertainable and its present value was fairly discounted was deductible from the gross-receipts while preparing the P & L Account. The material portion of the head-note appearing at page 54 of the report runs thus "Contingent liabilities discounted and valued as neces- ,_ sary, can be taken into account as trading expenses if they ' "Whether on the facts and in the circumstances of the case the Tribunal was justified in excluding a sum of Rs.

3,10,450 representing the dividends declared for the calendar year 1972 from the General Reserves on the opening date of the previous year while computing the capital under the Second Schedule of the Companies (Profits) Sur-tax Act, 1964 for the assessment year 1974-75? " Counsel for the assessee-company contended that after conceding that this was not a case of "proposed dividend" the Tribunal erred in holding that the sum of Rs 3,10,450 representing the dividends paid out from the General Reserve was liable to be excluded while computing the capital of the company as on 1. 1. 1973 • for purposes of sur-tax assessment under the 1964 Act. According to him under s. 205(1) of the Companies Act, 1956 dividend can be paid from out of the current year's profits or profits of any previous financial year or years and there is no presumption in law or in commercial accounting that a dividend has to be paid either from the current year's profits or from the past year' s profits.

He fnrther urged that once from out of the current year's profits a certain sum is transferred to the General Reserve it merges into the latter and the General Reserve so augmented becomes a conglomerate fund and if out of such conglomerate fund any sum is recommended or paid out as dividend it will be difficult to say that such payment has come out oL the portion of current year's profits that has been transferred and merged and there is no reason why the principle 'Last-in, First-out' should be invoked for drawing the inference that the payment has been made out of the current year's profits. He pointed out that such a principle was applied by the Bombay High Court in two decisions, namely, Commissioner of Income-Tax, 1 Bombay City·! v. Bharat Bij/ee Ltd. ( ) and Commissioner of Tncome- Tax, Bombay City-Tl v. Marrior (India) Ltd. (') but urged that there (! ) 107 ! TR 30. (2) 120 ! TR 512. VAZIR SULTAN TOBACCO v. C. I. T. (Tulz"purkar, J. ) 821 was no warrant for it.

In support of his contention that the entire General Reserve of Rs. 86,07,712 without any deduction should .. have been taken into account while computing the capital of the assessee-company, counsel relied upon a decision of the Andhra Pradesh High Court in Super Spinning Mills Ltd. v. Commissioner of JncomeTax, Hyderabad('). Alternatively counsel pointed out that as far as stock valuation is concerned a question often arises whether the stock on hand at the end of the year is to be valued at the closing price or at the initial purchase price and in 'Advanced Accounting' by R. Keith Yorston and E. Bryan Smyth (a treatise on the principles and practice of accounting in Australia) three methods of valuing the closing stock have been indicated at pages 441 and 442 of Vol. II (5th Edn. ) of the treatise, namely, (a) First-in First-out, (b) Lastin First-out and (c) Average Cost. In regard to these three methods the authors have stated thus .

(a) Pirst-in firs1-out The assumption underlying this method is that the oldest stock is used or issued first or that sales are ' made in the order in which the goods are purchased or produced. If there are several lots of goods at different prices, they are regarded as being exhausted in the order of pnrchase. On a rising market this would write off the lower-priced lots first, and on a falling market the higher-priced lots would go first. " (b) "Last-in First-out. This method assumes that the items of stock purchased are the first to be issued or sold and thus the stock remaining is valued at the cost of the earlier purchase. " (c) Average Cost. On this basis issues of stocks are valued at the weighted average cost of the stock on hand at the beginning and of the purchases, less any issues already made. " (! ) 107 ! TR 35. 822 lroi'REM~ COURT REPORTli {1982] I S. C. R. Counsel for the assessee urged that for determining whether the entire General Reserve of Rs.

86,07,712 or reduced General Reserve of Rs. 82,97,262 should be taken into account for capital computation either the 'First-in First-out' principle should be adopted; if not, only a proportionate deduction should be made and the balance should be held to be includible in capital computation, particularly because the payment of dividend has been from a > conglomerate fund. It is not possible to accept either of these contentions urged by counsel for the assessee-company. It is true that under s. 205(1) of the Companies Act, 1956 it is open to the directors to recommend and the share-holders to approve payment of dividends either from the current year's profits or from the past year's profits.

It is also true that on transfer of a portion of current year's profits to the General Reserve the augmented General Reserve becomes a conglomerate fund but having regard to the natural course of human conduct of hard-headed men of business and commerce it is not difficult to predicate that the dividends would ordinarily be paid out from the current income rather than from the past savings unless the directors in their report expressly or specifically state that payment of dividends would be made from the past savings.

From the commercial point of view if any amount is required for incurring any expenditure or making any disbursement like distribution of dividends in a current year, then ordinarily the same will come out of the current income of the company if it is available and only if the same is insufficient then the past savings will be resorted to for the purpose of incurring that expenditure or making that disbursement; such a course would be in accord with the common sense point of view. We may point out that this aspect of the matter was not considered by the Andhra Pradesh High Court in Super Spimdng Mills Ltd. case (supra) and the view of the Bombay High Court in the case of Bharat Bijlee Ltd. (supra) and Marrior (Indio) Ltd. (supra) commends itself to us.

Even in regard to the question of valuing the closing stock the learned authors of the treatise referred to by the counsel for the assessee-company merely indicate three methods for such valuation and it will be open to a commercial concern to avail of any one method. In our view in the context of the question whether while incurring any expenditure or making any disbursement a commercial concern will resort to current income or past savings, the normal rule, in the absence of express indication to the contrary, would be to resort to the current income rather than past savings. VAZIR SULTAN TOBACCO v. C. l. T. (A. N. Sen, J. ) 823 In our view, therefore, the Tribunal was right in excluding the sum of Rs. 3,10,450 from the General Reserves while computing the capital of the assessee-company for the assessment year 1974-75, in the absence of express indication to the contrary. In the result Civil Appeal No. 1614(NT) of 1978 and Review Petition No. 57 of 1980 are dismissed.

Civil Appeal No. 860 of 1973 is partly allowed and the issue whether the appropriation for retirement gratuity is a reserve or not is remanded to the Taxing \ Authority and the rest of the appeal is dismissed. In Tax Reference Cases Nos. 2 and 3 of 1977 and No. 5 of 1978 the questions referred to us are answered in favour of the Department and against the assessee-companies. Each party will bear its own costs in all the matters. AMARENDRA NATH SEN, J. At the outset I wish to observe that I have been somewhat diffident in hearing these matters. I felt a little embarrased as I found that as a Judge of the High Court at I Calcutta, I had an occasion to consider some of the questions in the case of Braithwaite and Co. (Indio) Ltd. v. Commissioner of Jncome- Tax, West Bengal, (') (Tncomc Tax Reference No. 262 of 1969).

As I have already considered some of the questions and have expressed my views on the same in the judgment delivered by me in the said reference, I was wondering whether I should hear these appeals. The members of the Bar. however, represented to me that they had not only no objection to my hearing these appeals but they also wanted me to hear these appeals. They further represented that most of the Judges of this Court had on some occasion or other considered these questions. They further stated that if I would decline to take up these matters not only the members of the Bar who had come from various parts of the country for these appeals would be seriously inconvenienced; but also the litigant public who had been waiting for years for the hearing of these matters would be prejudiced.

It was further pointed out to me that the judgment which was delivered by me was not under appeal and further it would appear from the judgment which I had earlier delivered in Braithwai1e matter, there was in fact a concession made by the learned counsel appearing on behalf of the assessee that the said case was covered by the decision of the Supreme Court in the case of Commissioner ofIncome· tax Bombay City v. Century Spinning and Manufacturing Co. Ltd. (1) The learned counsel appearing on behalf (1) [1978) III ! TR 727. (2) [1953) 24 ! TR 499. of the parties further represented to me that the earlier judgment was delivered by me as a Jndge of the High Court and it was always open to me to reconsider my view, particularly as a Judge of • this Court after bearing the submissions to be made by the learned counsel appearing on behalf of the parties.

In view of the aforesaid representations and submissions made by the learned 8 lawyers, I was persuaded to hear these appeals with my learned brothers to avoid inconvenience not only to the lawyers but to the ' litigant pnblic. I have also had no doubt in my mind that if I felt after hearing the submissions made by the learned counsel appearing on behalf of the parties in these appeals, that the earlier judgment delivered by me was wrong and incorrect, I would have no hesitation in reconsidering my earlier decision. I do not propose to set out the facts of this case at any length in this judgment. The facts have been fully and correctly set out in the judgment of my learned brother Tulzapurkar, J. My learned brother in his judgment has also dealt with the various arguments which were advanced from the Bar and has also considered the decisions which were cited.

I propose to notice only some of the decisions which, to my mind, are particularly important for decision of the question whether the provision made in the balance-sheet for payment of dividend to the share-holders recommended by the Board of Directors constitut· ed a 'reserve' and the amount, so set apart, should be taken into account, in computing the capital of the company for the purpose of Super·Profits Tax Act, 1963. It may be noted that in the Act itself the expression 'reserve' has not been defined. In the case of Commissioner of Income-tax, Bombay City v. Century Spinning and Manufucturing Co. Ltd. (supra), this Court had the occasion to consider the meaning of the word 'reserve' while dealing with a case under Business Profits ·Tax Act (XXI of 1947).

In this Act also, there were similar provisions with regard to computation of the capital of the Company and the assessee had claimed that the amount recommended by the Board of Directors and earmarked for payment of the dividend to the share-holders should be treated as 'reserve' and should be taken into consideration in computing the capital of the assessee. The Supreme Court observed at pp. 503-504 as follows :- "The term 'reserve' is not defined in the Act and we must resort to the ordinary natural meaning as understood VAZIR SULTAN TOBACCO v. C. I. T. (A. N. Sen, J. ) 825 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 for enjoying at once. 8 (b) To keep back or hold over to a later time or place or for further treatment. 6. To set apart for some purpose or with some end in view; to keep for some use. II.

To retain or preserve for certain purposes (Oxford Dictionary, Vol. VIII, P. 513. ) In Webster's New International Dictionary, Second Edition, page 2118 'reserve' is defined as follows: [) I. To keep in store for future or special use; to keep in reserve: to retain, to keep, as for oneself. . , 2. To keep back; to retain or hold over to a future time or place. • 3. To preserve. " The Supreme Court further observed at p. 504 : "What is the true nature and character of the disputed sum, must be determined, with reference to the substance of the matter? " The Supreme Court held at p. 504-505 as follows :- "A reserve in the sense in which it is used in rule 2 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. Therefore, giving to the 'reserve' its plain natural meaning it is clear that the sum of Rs.

5,08,63'/ was kept in reserve by the company and not distributed as profits and subjected to taxation. Therefore, it satisfied all the requirements of rule 2. The Directors had no power to distribute the sum as dividend. They could only recommend as indeed they did, and it was upto 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). " The Supreme Court also referred to S. 131 (a) and 132 of the Indian Companies Act. Referring to these sections the Supreme Court observed at p.

·sos as follows : "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 recom· mend 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 Ist 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. " In the case of Commissioner ofIncome Tax v. Standard Vacuum Oil Co. (') this Court had occasion to consider the decision in (I) [1966] 59 I. T. R. 685. VAZIR SULTAN TOBACCO v. C. l. T. (A. N. Sen, J. ) 827 the case of Commissioner of Income-tax v. Century Spinning and Manufacturing Co. Ltd. (supra). Dealing with the said decision of this Court held at p.

697-98 as follows :- "The Court was dealing in this case with the accounts of an Indian Company, tbe balance-sheet of which was prepared according to the provisions of the Indian Cc>mpanies Act, 1913. Regulation 99 of the First Schedule, Table A, required that reserves must be set apart before the directors recommended any dividend but out of the profits of the company no amount was set apart towards reserves before the directors recommended payment of dividend to the shareholders. The identity of the amount remaining on hand at the foot of the profit and loss account was not preserved. It is on these facts that the court held that there was no allocation of the amount to reserve and from the mere fact that it was carried forward in the account of the next year and ultimately applied in payment of dividend, it could not be said to be specifically set apart for any purpose at the relevant date, i. e. the end of the year of account. " This Court then proceeded to hold at p.

697-98 as follows :- "We are in this case dealing with a foreign company and the system of accounting followed by the company is different in important respects from the system which obtains in India. Companies in fodia maintain diverse types of reserves : such as capital reserve, reserve for redemption of debentures, reserve for replacement of plant and machinery, reserve for buying new plant to be added to the existing ones, reserve for bad and doubtful debts, reserve for payment of dividend and general reserve. Depreciation reserves within the limit prescribed by the Income-tax Act or the Rules thereunder is the only reserve which is a permissible allowance in the computation of taxable profits. In its ordinary meaning the expression 'reserve' means something specifically kept apart for future use or for a specific occasion. '' In the case of Metal Box Company of India Ltd. v. Their Workmen, (') this Court while dealing with a case under the pay- (1) [1963] 73 l. T. R. 53.

··~- ment of Bonus . Act, 1965 had occasion to consider the expression 'reserve' and its meaning for the purpose of the said Act. This Court held at p. 67-68 as follows :- "The next question is whether the amount so provided is a provision or a reserve. This distinction between a provision and a reserve is in commercial accountancy fairly well known. Provisions made against anticipated losses and contingencies are charges against profits and therefore, to be taken into account against gross receipts in the P & L account and the balance-sheet. On the other hand. reserves are appropriations of profits, the asset by which they are represented being retained in form part of the capital employed in the business. Provisions are usually shown in the balance-sheet by way of deductions from the assets in respect of which they are made whereas general reserves and reserve funds are shown as part of the proprietor's interest (see Spicer and Pegler's Book-keeping and Accounts, 15th Edn. page 42).

An amount set aside out of profits and other surpluses, not designed to meet a liability, contingency, commitment or diminution in value of assets known to exist at the date of the balance-sheet is a reserve , but an amount set aside out of profits and other surpluses to provide for any known liability of which the amount cannot be determined with substantial accuracy is a provision; (see • William Pickles Accountancy, Second Edn. p. 192; Part III, clause 7, Schedule VI to the Companies Act, 1958, which derives provision and reserve. " In the case of Commissioner of Income-tax v. Mysore Electrical Industries Ltd. (') the facts were briefly as follows :- Out of the profits of the company for the accounting period ending March 31, 1963. the Directors of the company appropriated the following amounts towards reserves on August 8, 1963 : (i) Rs. 2,56,000 as plant modernisation and rehabilitation rese1ve : (ii) Rs. 89,557 as development rebate reserve.

The question was whether these amounts could be included in computing the capital of the respondent as on April I, 191i3 under rule I of Schedule II to the Companies (Profits) Sur-tax Act, 1964, for the purpose of the statutory deduction for the assessment year 1964-65, The contention of the c'epartment was that since the appropriations were made on 8th August, 1963 they could not be treated as components of capital as on the first day of the previous year i. e. ! st April, 1963. Negativ- (l) [1971) SO ITR 567. I I•· VAZIR SULLAN TOBACCO v. C. l. T. (A. N. Sen, J. ) 829 ing the contention of the department, this Court held that the determination of the Directors to appropriate the amounts of the three items of reserve on 8th August, 1963 bad to be related to first April, 1963, viz.

, the beginning of the accounts for the new year, and had to be treated as effective from that day and the said three items had to be added to the other items for computation of the capital of the company as on first April, 1963 under rule 1 of Schedule II to the Companies (Profits) Sur-tax Act, 1964. It may be noted that in this case before the trial court a claim had been made by the company that a sum of Rs. 3,15,000 representing dividend reserve was to be considered in computing the assessee's capital for the purpose of Companies (Profits) Sur-tax Act, 1964 and the High Court had rejected this claim. As against the rejection of this claim by the High Court, no appeal bad been preferred by the assessee to the Supreme Court. The Supreme Court while considering the three items which came up for consideration before it held, as already noted, that the decision of the directors to appropriate the amounts to these three items of reserve on 8th August, 1963 had to be related J to !

st April, 1963 and this Court observed at pp. 560-570 as follows:- "It is well known that the accounts of the company • have to be made up for a year up to a particular day. In this cas~ that day was the 31st March, 1963. If it was • reasonably practicable to make up the accounts up to the 31st March, 1963, and present the same to the directors of the respondent on April 1, 1963, they could have made up their minds on that day and declared their intention of appropriating the said and other sums to reserves of different kinds. But the fact that they could not do so for the simple reason that the calculation and collection of figures of all t11e items of income and expenditure of the company for the year ending 'March 31, 1962, was bound to take some time cannot make any difference to the nature or quality of the appropriation of the profits to reserves as determined by the directors after the first of April, 1963.

Their determination to appropriate the sums mentioned to the three separate classes of reserves on the 8th August, 1963, must be related to the ! st of April, 1963, i. e. , the beginning of the accounts for the new year and must be treated as effective from that day". Relying on the aforesaid decisions and also many other decisions of the various High Courts which have been considered by my learned brother Tulzapurkar, J. in his judgment, the learned counsel for the assessee has argued that the word 'reserve' which has not been defined in the Act, has to be understood in its ordinary meaning as laid down by the Supreme Court in the case of Century Spinning Mills Ltd. The further argument is that the recommendation for dividend by the directors of the Company does not creat any kind of liability, immediate ot future.

It is argued that the • obligation to pay the dividend only arises when the shareholders at the Annual General Meeting of the Company decided to accept the recommendation of the Directors and pass a resolution for declaration of dividend. It is submitted that it is open to the I>irectors to withdraw or modify the recommendations made by them any time before the shareholders accept the recommendations and in support of this contention reference is made to the decision of this Court in the case of Keshoram Industries and Cotton Mi//s Ltd. v. Commissioner of Wealth Tax (Central), Calcutta. (') and reliance is placed on the following observations at p. 772 :- "The directors cannot distribute dividends but they can only recommend to the reneral body of the company the quantum of dividend to be distributed.

Under section 217 of the Indian Companies Act, there shall be attached to every balance-sheet laid before a company in general meeting a report by its board of directors with respect to, inter alia, the amount, if any, which it recommends to be paid by way of dividend. Till the company in its general body meeting accepts the recommendations and declares the dividend, the report of the directors in that regard is only a recommendation which may be withdrawn or modified as the case may be. As on the valuation date nothing further happened than a mere recommendation by the directors as to the amount that might be distributed as dividend, it is not possible to hold that there was any debt owed by the assessee to the shareholders on the valuation date. " It is further argued that it is open to the share-holders to accept the said recommendations in its entirety or to modify the same by (I) [1966) 59 ! TR 767. VAZIR SULTAN TOBACCO v. C. LT. (A. N. Sen, J.

) 831 deciding to declare dividend at a rate lower than the one recom· mended by the directors. It is, therefore, contended that the recommendation of the directors for payment of dividend does not have the effect of creating any kind of liability and there is no . debt owed by the company by virtue of the said recommendations. It has been submitted that the decision of this Court in the case of 8 Mysore Electrical Industries Ltd. (supra) is of no assistance and the said decision does not. lay down that in the event of the shareholders' acceptance of recommendation made by the directors for the distribution of dividend to the share-holders of the company, the liability for payment of the dividend will also relate back; and the doctrine of relation-back applies only in respect of items which the directors are competent to decide for themselves, in view of the process involved in the preparation of accounts of the company.

J The main argument advanced on behalf of the Revenue is that any amount which may be set apart for payment of dividend recommended to be paid by the Directors cannot constitute 'reserve' within the meaning of the Act. The argument advanced on behalf of the assessee appears to • be sound; but to my mind the said arguments are not snfficiently convincing to lead the Court to the conclusion that the amount set apart for payment of dividend recommended by the Board of Directors can constitute 'reserve' within the meaning of the Act for the purpose of computation of the capital of the Company. The word 'reserve' bas not been defined in the Act. In the absence of any such definition the word has to be understood in its ordinary sense. It is, however, to be remembered Jthat the word 'reserve' in the instant case occurs in a taxing statute specially applicable to Companies only.

The word 'reserve' should be so construed as to give the said word the meaning in which it is ordinarily understood by persons interested in Companies or in dealing with Companies. In other words, the word 'reserve' for the purpose of this Act should be understood in the sense in which it is understood in company circles and by persons interested in Companies and in dealing with Companies. It may be noticed that while considering the true meaning and true nature of'reserve', the Supreme Court in the case of Commissioner ofIncome Tax v. Century Spinning and Manufacturing Co. Ltd. (supra) has referred i • to S. 131 (a) and 132 of the Indian Companies Act, to the Form marked F in Schedule III in which balance sheet of the Company has to be prepared and also to Regulation 99 of the First Schedule, Table A. I have earlier quoted the relevant observations of the Supreme Court. It is, no.

doubt, true that the recommendations of the Directors for payment of any dividend does not create any kind of liability for the payment of the said amount. The liability for payment of any amount by way of dividend only arises when the share-holders accept the recommendations and a dividend is declared at the annual general meeting of the Company. ' It is open to the Directors to modify or withdraw the recommendation with regard to the payment of dividend before the said recommendation is accepted by the share-holders. It is also open to the share-holders not to accept the recommendation of the Directors in its entirety and to modify the same. The legal liability for the payment of any dividend only arises after the share-holders at the annual general meeting have decided to declare a dividend on the basis of the recommendations of the Directors or on the basis of any modification thereof.

The liability for the payment of dividend only arises after the dividend has been declared by the share-holders at the • annual general meeting and this liability does not relate back to any earlier date on the basis of the recommendations of the directors, as the directors do not enjoy any power of declaring the dividend. The amount that may be set apart for payment of any dividend on the basis of the recommendations made by the Directors, cannot be considered to be an amount set apart for meeting a known or existing liability. Though the amount which is set apart for payment of any dividend recommended by the Board of Directors is not an amount set apart for meeting any known or existing liability, yet the said amount so set apart cannot be considered to be a 'reserve' within the meaning of the Act for the purpose of computation of the capital of the Company. S.

210 of the Companies Act, 1956 specifically provides that at every annual general meeting of a Company the Board of Directors of a Company shall lay before the Company the balance sheet of the Company and. also the Profits and Loss account. S. 2ll VAZIR SULTAN TOBACCO v. C. l. T. (A. N. Sen, J. ) 833 further provides that every balance sheet of a Company shall give true and fair view of the state of affairs of the Company as at the end of the Financial Year and· shall, subject to the provisions of the section, be in the form set out in Part I of Schedule VI, or as near thereto as circumstances admit or in such other form as may be approved by the Central Government either generally or in a particular case. The preparation of a balance sheet in the prescribed form and laying the same before the share-holders at the annual I meeting are statutory requirements which the Company has to observe.

Regulation 87 of Table A in Schedule I provides : "(I) The Board may, before recommending any dividend, set aside out of the profits of the Company such ) sums as it thinks proper as a reserve or reserves which shall, at the discretion of the Board, be applicable for any purpose to which the profits of the Company may be properly applied, including provisions for meeting contingencies or for equalising dividends; and pending such application, may at the like discretion, either be employed in the business of the company or be invested in such • investments (other than shares of the Company) as the Board may from time to time, think fit. (2) The Board may also carry forward any profits which it may think prudent not to divide. without setting them aside as a reserve".

This Regulation contemplates that the Board may set aside out of the profits of the Company such sums, as it thinks proper, as a - reserve or reserves which shall, at the discretion of the Board, be applicable for any purpose to which the profits of the Company may be properly applied including the provisions for meeting contingencies or for equalising the dividends, before recommending any dividend. In other words, the sums out of the profits of the Com· pany have to be set apart as reserve before any dividend is recommended by the Board; and the recommendation of the Board for payment of dividend comes only after the creation of reserve. The amount that may, therefore, be set apart for payment of dividend recommended by the Board is an amount which is set apart after the Board had created the re•erve. The form of balance sheet referred to in S. 211 of the Companies Act, 1956 is appended in Part I of Schedule VI of the Statute.

In the statutory form there are various heads including heads of various kinds of reserves and also of provisions. In the balance sheet of the Company which has necessarily been prepared in accordance with the provisions of the statute and in the form prescribed, the amount recommended by the Board for payment of dividend has been shown under the head provisions and not under any head of reserves. It is, no doubt, true that the true nature and character of the sum so set apart must be determined with regard to the substance of the matter. The substance of the matter clearly appears to be that the amount is set apart for payment of dividend recommended by tbe Board to be paid to the share-holders and the said amount is never intended to constitute a reserve of the Company. Indeed a provision is made for payment of the said amount to the share-holders by way of dividend on the basis of the recom_mendation made by the Directors.

Though in law the recommendation made by the Directors for payment of dividend to share-holders does not create any liability for the payment of dividend and liability only arises when the shareholders accept the said recommendation, and though in law it may be open to the Board to modify or withdraw the :·recommendation with regard to the ~payment of dividend before the acceptance by • the share·holders and it may also be open to the share-holders not to accept the said recommendation in its entirety and to modify the same, yet.

for business pusposes, when the directors make any recommendation for payment of dividend and set apart any amount for the payment of dividend so recommended, the directors intended to make a provision for the payment of dividend recommended by them and not to create any reserve, as the Directors very well know that the recommendation made by them with regard to the payment of dividend is not normally up-set by the share·holders and it is generally accepted by the share-holders, as a matter of course. Any • amount set apart by the Directors for payment of dividend to the share-holders recommended by them, is understood by persons interested in company and in dealing with companies to mean a provision for the payment of dividend to the share-holders and is not understood to constitute a reserve.

In my opinion, this true nature and character of the sum so set apart are reflected in the provisions of the Companies Act and more particularly in the manner of preparation of the balance-sheet of the Company. I am, therefore, of the opinion that the amount set apart for the payment VAZIR SULTAN TOBACCO v. C. l. T. (A. N. Sen, J. ) 835 of any proposed dividend on the basis of the recommendation :or the Directors cannot constitute reserve for the purpose of computation of the capital of the Company. The view that I have taken, to my mind, appears to be in accord with the view earlier expressed by this Court in the decisions to which I have already referred. On the other questions, I entirely agree with the view expressed by my learned brother Tulzapurkar, J. and I agree with the Jorder proposed by him. C. A. No. J614(NT)/78, Review Petition No. 57/80 and Tax Reference Caoes Nos. 2&3/77 and 5/1978 dismissed. P. B. R. C. A. No. 860/73 partly allowed. j