1. This is a reference in a case stated under s. 256(1) of the I.T. Act, 1961, as applied to the Companies (Profits) Surtax Act, 1964 (referred to hereinafter as 'the said Surtax Act'). The questions referred to us for out determination are as follows :
'(1) Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the entire amount standing to credit of the General Reserves as on the first day of the previous year should be included in the capital computation for the purpose of the Surtax Act, 1964, without reducing therefrom any sum in respect of the amount capitalised subsequently during the succeeding year for issuing bonus shares ?
(2) If the answer to question No. 1 above is in the negative, then whether Rs. 27,18,000 being the entire amount capitalised, or Rs. 15,19,101 up capital for bonus share issued, should be reduced from general reserves as on the 1st day of the previous year ?
(3) Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the amount standing to the credit of the reserves for bad and doubtful debts account was a reserve and not provision, and, hence, includible in the capital computation ?'
2. The facts relevant to the first two questions are as follows :
3. The assessment year in question is the assessment year 1968-69, the relevant previous year is the year July 1, 1966, to June 30, 1967. The computation of the capital for the purpose of Surtax Act, it is common ground, has to be as on July 1, 1966. The relevant balance-sheet is the one as the June 30, 1966. Under rule 1 of the Second Schedule to the Surtax Act, the capital of the company shall be the aggregate of the amounts as on the first day of the previous year of the paid up share capital, development rebate reserves, 'other reserves', debentures and certain borrowed funds. The assessee claimed that the balance Rs. 37,70,000 in the general reserve account as on July 1, 1966, was includible in the term 'other reserves' under the rule 1. The ITO did not accept this claim and reduced the aforesaid amount claimed to be the balance of the general reserves by a sum of Rs. 27,18,000 which was capitalised and utilised for issuing bonus shares during the relevant previous year. The director's report for the year ending June 30, 1966, which was dated November 22, 1966, mentioned that the assessee-company, i.e. the directors of the assessee-company, had decided to issue bonus shares. The resolution for the issue of bonus shares and capitalising the aforesaid amount of Rs. 27,18,000 out of the general reserves for that purpose was passed at an extraordinary general meeting of the shareholders held on October 31, 1966, that is, after July 1, 1966. The ITO held that out of the general reserves of the assessee, a sum of Rs. 27,18,000 had been earmarked as early as on June 30, 1966, for the issue of bonus shares and was in the nature of provision and not a reserve. The ITO, however, added in the capital computation, a sum of Rs. 15,19,101 under rule 3 of the aforesaid Second Schedule to the Surtax Act, as the increase in capital on a pro rata basis, taking into consideration the number of days for which the increase in the share capital was effective during the previous year. The Income-tax Appellate Tribunal held that this addition to the extent of Rs. 15,19,101 on account of the increase in capital as contemplated in rule 3 of the aforesaid Second Schedule was properly made by the ITO, still he was not justified in reducing from the capital computation the sum of Rs. 27,18,000 in so far as on the first day of the previous year (July 1, 1966), there was no liability towards the payment of bonus shares, such liability having arisen only after October 31, 1966. The Tribunal did take note of the fact that as a result of its decision, the assessee would get a double advantage, but felt that that would make no difference to the situation.
4. As far as the third question is concerned, the Tribunal pointed out that it related to the inclusion in 'other reserves' of a sum of Rs. 16,854 standing to the credit of 'Reserve for bad and doubtful debts account'. The Tribunal found that this account was being brought forward in the assessee's books right from 1955, and the Tribunal accepted the statement of the assessee that, in fact, if in any year, any debt had become actually bad then it was debited straightaway to the profit and loss account of that year and the reserve account was not touched at all. In view of the aforesaid, the Tribunal agreed with the contention of the assessee that the said account was not in the nature of a 'provision' but was only a 'Reserve'.
5. As far as question No. 1 is concerned, it is a well settled position in law that when directors declare their decision to issue bonus shares no liability is incurred by the company at least till a resolution for the issue of bonus shares is passed at an extraordinary general meeting of the share-holders. The question whether such liability accrues at the time when such a resolution is passed or at the time when such shares are actually issued and allotted is a question with which we are not concerned. But it is well settled that no liability on that account accrues till the resolution as aforesaid is passed by the shareholders of the company. In view of this, it is quite clear that at least till the resolution was passed as aforestated on October 30, 1966, it could not be said that the amount of the general reserves stood reduced by the amount intended to be capitalised for the issue of bonus shares or that the amount required for the purpose of such capitalisation was converted from its character as general reserves to the character of a provision. We are supported in this view by the decision of the Supreme Court in Kesoram Industries and Cotton Mills Ltd. v. CWT : 59ITR767(SC) . In that case, the directors of the appellant-company had shown in its profit and loss account for the year ending March 31, 1957, a sum of Rs. 15,29,855 as the amount of dividend proposed to be distributed for that year. The dividend was declared by the company at its general meeting held in November, 1957. The question was whether the amount so set apart as dividend was a debt owed by the company on the valuation date, viz., March 31, 1957, and was, as such, deductible in computing the net wealth of the company as on the valuation date. It was held that until the company in its general body meeting accepted the recommendation of the directors and declared the dividend, the report of the directors in that regard was only a recommendation which might be withdrawn or modified.
6. In connection with the said question, Mr. Parekh placed reliance on the judgment of the Supreme Court in CIT v. Mysore Electrical Industries Ltd. : 80ITR566(SC) . That case arose under the Companies (Profits) Surtax Act, 1964, namely, the aforesaid Surtax Act. In that case, out of the profits of the respondent-company for the accounting period ending March 31, 1963, the director of the company appropriated towards reserves on August 8, 1963, (i) Rs. 2,56,000 as plant modernization and rehabilitation reserve; (ii) Rs. 1,00,000 as loss of repatriation reserve; and (iii) Rs. 80,557 as development rebate reserve. The question was whether these amounts could be included in computing the capital of the respondent as on April, 1, 1963, under rule 1 of Schedule II to the Companies (Profits) Surtax Act, 1964, for the purpose of the statutory deduction for the assessment year 1964-65. The Department contended that since the appropriations were made on August 8, 1963, they could not be treated as components of capital as on the first day of the previous year, namely, April 1, 1963. The contention of the Department that the determination of the directors to appropriate the amount to the three items of reserve on August 8, 1963, had to be related to April 1, 1963, namely, the beginning of the accounts for the new year, and had to be treated as effective from that day was rejected and all the three items were added to the computation of the capital of the respondent as on April 1, 1963. We fail to see how this decision renders any support to the contention of the Department in this case. We may, moreover, point out that as far as the appropriation of certain items towards certain type of reserves by the directors is concerned, there was no question of any liability being thereby created against the company, whereas once there is declaration of dividend or a resolution is passed by the shareholders for the issue of bonus shares, the situation might be different.
7. Mr. Parekh next relied upon a decision of a Division Bench of the Madras High Court in Rane Brake Linings Ltd. v. CIT : 144ITR340(Mad) . In that case, out of the profits for the year ending on December 31, 1970, the directors of the assessee-company decided to credit a sum of Rs. 13,32,992 to the company's general reserve and also recommended payment of a dividend of Rs. 2,03,250 out of the general reserve. The recommendation of the directors made on May 4, 1971, was approved by the general body on June 16, 1971, and the dividend was paid subsequently before the close of the year ending December 31, 1971. For determining the capital of the company as on January 1, 1971, for liability to surtax for 1972-73, the assessee's claim that the sum of Rs. 13,32,992 transferred to the general reserve should be taken into account without any deduction for the dividend which was declared subsequently was negatived by the ITO as well as by the Tribunal. This decision was upheld by the Division Bench.
8. It was submitted by Mr. Parekh, on the basis of this decision, that in the present case also the amount out of the general reserve utilised during the previous year for capitalization by the issue of fully paid up bonus shares should be deducted from the general reserve in computing the capital. We find that, on a proper analysis, this case does not support the case of the Department. In the first place, the declaration of dividend cannot be regarded as identical with the issue of bonus shares as far as the legal position is concerned. The facts of the Madras case, Rane Brake Linings Ltd. v. CIT : 144ITR340(Mad) , are also peculiar. It was out of the profits of the year ended December 31, 1970, that the assessee decided to credit Rs. 13,32,992 to the company's general reserve. Having done so, the directors recommended that a dividend be declared for the year ended December 31, 1970, at a rate which worked out to a total commitment of Rs. 2,03,250. They decided to pay the dividend from out of the general reserve. The Board's recommendation was May 4, 1971. The general body meeting approved of the dividend on June 16, 1971. The dividend was actually distributed subsequently, but before close of the year ended December 31, 1971. These facts show that at the very time when the amount of Rs. 13,32,992 was taken out of the profits to the general reserve of the assessee-company, the clear intention of the directors was to earmark out of this amount, a sum of Rs. 2,03,250 for the payment of the dividend on the profit of the year ended December 31, 1971. The principle of the decision does not appear to be that the payment of the dividend out of the general reserve relates back to the first day of the previous year and, hence, the amount required for such payment is liable to be deducted from the general reserve as computed on the first day of the previous year. The basis of the judgment seems to be that on the facts of that case, right at the time when the amount of Rs. 13,32,992 was transferred from the profit and loss account to the general reserve, the amount of Rs. 2,03,250 out of the same was earmarked for the payment of the dividend and that amount could be regarded as a provision and deducted out of the general reserve in the computation of capital. The facts, in this case, are altogether different. In the present case, there is nothing to show that the amount of Rs. 37,70,000 was brought into the general reserve from the profits of the year ended June 30, 1966. In fact, the balance-sheet shows that the bulk of this amount was general reserve which had been carried forward. Moreover, there is nothing to show that there was any amount earmarked for payment of bonus shares at the time when any part of the profits of the year ending June 30, 1966 were brought into the general reserve. All that happened was that by June 30, 1966, the directors had recommended the issue of bonus shares. The ration of the Madras case, Rane Brake Linings Ltd. v. CIT : 144ITR340(Mad) is, therefore, not applicable to the case before us. In view of what we have observed above, it is clear that question No. 1 must be answered in the affirmative and against the Department and if favour of the assessee.
9. Coming now to question No. 2, we find that the very frame of the question makes it clear that it requires to be answered only in the event of question No. 1 being answered in the negative, i.e., in favour of the Department. That would be necessarily so because that question is only regarding what is the amount which should be deducted from the general reserve for capital computation. It was, however, sought by Mr. Parekh, on the basis of this question to contend that the sum of Rs. 15,19,101 being the proportionate amount calculated as aforestated should not have been added by the ITO or the Tribunal to the paid up capital of the assessee-company in the capital computation under rule 3 of the said Schedule II to the said Surtax Act, because when a part of an amount standing to the credit of the general reserve is capitalised by issue of fully paid up bonus shares, it cannot be said that the capital of the company computed in accordance with rule 1 of the Second Schedule is increased by any amount by the issue of such bonus shares. He states that the aforesaid proposition is supported by the decision of a Division Bench of this court in CIT v. Century Spg. and Mfg. Co. Ltd. : 111ITR6(Bom) . In our view, it is not open for Mr. Parekh to raise this contention at all because, as we have already observed, question No. 2 is itself in the form of an alternative and pertains to the amount to be deducted from the general reserve and does not relate to the computation of the paid up capital of the assessee company at all.
10. Coming now to question No. 3, we find that the facts found by the Tribunal show that the amount of Rs. 16,854 was being brought forward in the assessee's books as standing to the credit of 'Reserve for bad and doubtful debt account' right from the year 1955. This would clearly show that whenever debts became bad or doubtful, they were directly written off from the profit and loss account or some other account. It was in view of this that the Tribunal accepted the statement made on behalf of the assessee that according to the practice of the assessee, if in any year any debt became actually bad, then it was debited straightaway in the profit and loss account and the aforesaid reserve account was not touched at all. This finding of fact would show that the amount of Rs. 16,854 was really in the nature of a 'reserve' and not an amount kept by way of a 'provision' to meet any particular liability. It is now well settled that an amount set aside out of the 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. (See Vazir Sultan Tobacco Co. Ltd. v. CIT : 132ITR559(SC) and Parke Davis (India) Ltd. v. CIT : 130ITR813(Bom) .
11. In the result, question No. 3 must be answered in the affirmative and in favour of the assessee.
12. Department to pay to the assessee costs of the reference.