1. Two questions have been referred for our decision :
'1. Whether, on the facts of this case, the two sums of Rs. 9,56,838 in the chargeable accounting period ended March 31, 1947, and Rs. 10,15,242 in the chargeable accounting period end March 31, 1949, shown in the accounts with the narration 'contribution from outside parties for capital expenditure' are reserves coming within the scope of Schedule II, rule 2, of the Business Profits Tax Act
2. Whether, on the facts of the case, the investments referable to the contribution from employees can be deducted under Schedule II, rule 2, in the assessment for the chargeable accounting period ended March 31, 1947 ?'
2. Though the questions are couched in different forms the short question that we have to determine is whether the amount of the 'contribution from outside parties for capital expenditure' and the amount pertaining to half of the works provident fund, namely, Rs. 77,79,221, being the amount contributed by the employees, constitute 'reserves' within the meaning of rule 2 of Schedule II of the Business Profits Tax Act. The question arises under the following circumstances :
We are concerned with two 'chargeable accounting periods' ending on March 31, 1947, and March 31, 1949. Under section 4 of the Business Profits Tax Act the charge of tax is in respect of any business to which the Act applies 'on the amount of the taxable profits during any chargeable accounting period ...' 'Taxable profits' is defined in section 2(17) as meaning the amount by which the profits during a chargeable accounting period exceed the abatement in respect of that period. Therefore, the tax is leviable on the amount by which the profits during the chargeable accounting period exceed 'the abatement' in respect of that period.
3. 'Abatement' is defined in section 2(1) to mean 'in respect of any chargeable accounting period ending on or before the 31st day of March, 1947, a sum which bears to a sum equal to -
(a) in the case of a company, not being a company deemed for the purposes of section 9 to be firm, six per cent. of the capital of the company on the first day of the said period computed in accordance with Schedule II, or one lakh of rupees, whichever is greater ......
The same proportion as the said period bears to the period of one year .....' (We quote only the portion applicable.)
4. With the rest of the definition we are not concerned. Thus, the amount of abatement should be a sum equal to 6% of the capital of the company on the first day of the chargeable accounting period computed in accordance with Schedule II of the Act.
5. Schedule II of the Act contains the rules for computing the capital of a company for the purposes of business profits tax and at the material time rule 2 was as follows :
'2. (1) Where, the company is one to which rule 3 of Schedule I applies, its capital shall be the sum of the amount of its paid-up share capital and of its recesses 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, 1922 (XI of 1922), diminished by the cost to it of its investments or other property the income from which is not includible in the profits, far as the cost exceeds any debt for money borrowed by it.
(2) In all other cases, the capital shall be the sum ascertained in accordance with the said sub-rule, diminished by the cost to the company of its investments so far as that cost exceeds an debt for money borrowed by it.
Explanation. - A reserve or paid-up share capital brought into existence by creating or increasing (by revaluation or otherwise) any book asset is not capital for the purposes of ascertaining the abatement under this Act, in respect of any chargeable accounting period.'
6. The two chargeable accounting periods with which we are here concerned are the periods ending March 31, 1947, and the amounts in regard to which the two questions arise in the respective chargeable accounting periods were as follows :
Chargeable accounting period ended : 31-3-1947 31-3-19491. Contribution from outside Rs. 9,56,838 Rs. 10,15,242parties for capitalexpenditure.2. Half of works provident fund.Rs. 77,79,221 Nil.
7. It is an admitted position between the parties that the assessee-company is not one to whom rule 3 of Schedule I of the Act applies, in that its business does not consist wholly or partly in dealing or holding of investments. The amounts in the two chargeable accounting periods referred to as contribution from outside parties for capital expenditure were, it appears, received by the assessee as a contribution from the Central Government for certain certain capital purposes. The assessee by virtue of its special position as manufacturer of steel was receiving certain bounties from the Government of India and other parties for capital purposes, and the two amounts of Rs. 9,56,838 and 10,15,242 were shown by the company in their balance-sheet on the 'capital and liabilities' side with the narration 'contribution from outside parties for capital expenditure'. The question was whether these amount constitute 'reserves' and should, therefore, be included in the computation of the capital of the company. If they are so included the abatement to be deducted from the total profits of the company will to that extent increase and correspondingly reduce the tax burden upon the assessee. If, however, they are not included in the reserves in so far as they have not been allowed in computing the profits of the company, then to that extent the abatement will decrease with the corresponding result that the taxable profits will increase.
8. On this question the Business Profits Tax officer held that these amounts did not form part of any of the company's reserves not allowed in computing the company's profits for income-tax purposes and, therefore, they cannot be include in the capital under any of the provisions of schedule II.
9. In appeal the Appellate Assistant Commissioner confirmed the decision of the Business profits tax Officer and held these were amounts received by the assessee from outside parties meant for certain purposes and could not for that reason be called 'reserve'. He emphasised that the Supreme Court had decide what were the essentials of a 'reserve' within the meaning of schedule II of the Business Profits Tax Act and by that definition there should be some setting apart of this amount for a special or general purpose by those in the company who are empowered and authorised by the articles of association to allocate the funds of the company for a particular purpose. Moreover, the company itself had not then these amounts to a reserve account and, therefore, it must be held that the amounts did not form part of any of the company's reserves.
10. In a further appeal by the assessee the Tribunal agreed with the assessee. It held that the absence of the nomenclature 'reserve' with regard to these items did not stand in the way of these items being taken as reserve and that in any case rule 2 of schedule II did not define what 'reserve' was and it only provided for the inclusion of certain items. It held that these items could only be retarded as reserves. The Tribunal followed the decision of the Calcutta High Court in Commissioner of Income-tax v. Standard Vacuum Oil Co., and pointed out that it was not necessary that the reserve should actually come out of the taxed or taxable profit. Rule 2 did not stand in the way of capital reserves (which are realisations out of sale of capital assets) being taken into account for the purpose of computing the reserves. For these reasons, the Tribunal accepted the assessee's contention and held that these two amount could be held to be 'reserves'.
11. On behalf of the Commissioner Mr. Joshi has urged on the first question that the Tribunal erred in its interpretation of rule 2 and particularly in the interpretation of the word 'reserve'. He relied upon several authorities to which we shall presently refer and contended that whatever met be the meaning of the word 'reserve' in other contexts, in the context in which it is used in rule 2 of Schedule II, the word 'reserve' only shows that it must be a reserve which arises out of profits. In this context counsel for the department stressed that in rule 2(1 the word 'reserves' is immediately followed by the words 'in so far as they have not been allowed in computing the profits.' Therefore, he urged that 'reserve' must necessarily have reference to the computation of profits and in the particular context in which the word is used it can only mean 'reserves' arising out of profits. Another contention of contention of counsel has been that even having regard to the ordinary connotation of the word 'reserve' to be found in the case to which we shall refer, viz., a specific amount set apart for a specific purpose, upon the facts and circumstances of this case, there is nothing to show that this amount was in fast set apart for a specific purpose. All that has been established in the present case is that the Central Government and other parties paid a certain subsidy or contribution to the company. For what purpose it is paid has not been established and, therefore, there is no specification of the purpose for which this amount has been received by the company and so it could not partake of the nature of 'reserve'. In other words, the contention was that it was a sort of a general reserve or an amount in the hands of the company held for am unspecified purpose.
12. Turning to the first contention, the matter is set at rest by the recent decision of the Supreme Court in Commissioner of Income-tax v. Standard Vacuum Oil Co. That decision was given in an appeal to the Supreme Court against the decision of the Calcutta High Court Commissioner of income-tax v. Standard Vacuum Oil Co. The Supreme Court affirmed the decision of the Calcutta High Court. The facts in the Standard Vacuum oil Company's case were these : The assessee, the Standard Vacuum Oil Company, decided to take over the assets of two other companies, namely, the Socony Vacuum Oil Company and the standard Oil Company (New Jersey). The assets of these two companies on 1st January, 1934, stood at $97,715,701 and $46,767,397. As a consideration for the transfer by the company of their assets, each of the two company were allotted 49,995 shares of assessee-company and one of them was further allotted certain serial bonds of the face value of $13,093,000. The balance of 10 shares in the assessee-company were also allotted to each of these company equally for cash. The assessee-company valued the assets taken over of the two companies, as in excess of the par value of their shares allotted to the two companies and the par value of the bonds and entered the excess in an account styled 'capital paid in surplus'. The net profits earned by the company year after year were entered in the balance-sheet under the caption 'earned surplus'. After the bonds were redeemed by the assessee-company there was also a considerable surplus in the accounts of the assessee-company. This surplus amount was entered by the company in its accounts against the entry 'capital paid in surplus'. The question was whether these amount so appearing in the books of the company as 'capital paid in surplus' and 'earned surplus' could be treated as reserves within the meaning of rule 2(1) of Schedule II of the Act. The point for determination this case, therefore, directors under the very provision with which we are concerned.
13. In that case one of the arguments advanced by counsel of behalf of the revenue was the very same argument which counsel for the department had advanced in the present case and it is stated at page 693 as follows :
'.... that reserves contemplated by rule 2(1) are only those which are built out of profits processed for the purpose of taxation under the Indian Income-tax Act.'
14. The Supreme Court negatived this contention pointing out that in their earlier decision in Commissioner of Income-tax v. Century Spinning and ., they had already indicated what was the definition of 'reserve'. 'In its ordinary meaning the expression 'reserve' means something specifically kept apart of future use or for a specifically occasion' (see page 698), and they held that upon that meaning the amount in the 'capital paid in surplus : account were reserves as also the amounts in the 'earned surplus' account. The profit of the company being allocated to the 'earned surplus' account were reserves as also the amounts in the 'earned surplus' account. The profit of the company being allocated to the 'earned surplus' account was intended to designate a fund to be utilized for the purpose of the business of the company which retained its identity year after year and so represented 'reserves'.
15. So far as rule 2 is concerned the Supreme Court pointed out that two essential characteristics must be present before the assessee can avail him-self of the benefit of rule 2 : firstly, that the amount should not have been allowed in company the profits of the company for the purposes of the Income-tax Act, and, secondly, that it should be a reserve as contemplated by the rule. In the Century Mills case, in the decision of this court from which appeal before the Supreme Court arose, there were certain remarks made in the judgment of Chief Justice Chagla to suggest that reserves can only arise out of profits. These remarks were as follows :
'In order to determine the capita of the company for the purposes of this Act you have got to take the paid-up share capital of the company, then you have to add to it the reserves and you have to add only those reserves which have been subjected to taxation', and the further remarks at page 265 of 20 I.T.R. : 'A reserve in the sense in which it is used in rule 2 can only mean profit earned any a company not distributed as dividends to the share-holders but kept back by the directors for any purpose to which it may be put in future.'
16. In their decision in the standard Vacuum Oil Company's case the Supreme Court pointed out (vide page 694), that these remarks of chief Justice Chagla were only made with reference to the facts of that case and were not intended to lay down that reserves built up from sources other than profits will not be admissible for inclusion in capital under rule 2(1) of the Business Profits Tax Act, and that such a contention was also negatived by the terms of the Explanation to rule 2. That court remarked :
'Reserves which may be brought into existence by creating or increasing (by revaluation or otherwise) any book asset are expressly declared to be not capital for the purpose of ascertaining the abatement. If reserves which were built not of profit were excluded from the operation of rule 2(1), it was hardly necessary to enact the Explanation.'
17. We may also stress here that the decision in the Standard Vacuum Oil Company's case arose out of the decision of the Calcutta High Court and in the latter decision at page 659 the Calcutta High Court had expressly dissented from the remarks of chief Justice Chagla. At page 660 Justice Mitter observed :
'The learned Chief Justice said that 'in order to determine the capital of the company for the purpose of this Act you have got to take the paid-up share capital of the company, then you have to and to it the reserves and you have toad only those reserve which have been subjected to taxation'. With great respect to his Lordship I cannot see why reserves must necessarily have be subject to taxation before they can be added to the paid-up share capital of the company to determine the abatement permissible under the Act. If for instance a company had certain reserves created before the Indian Income-tax Act, 1922, came into force, I see no reason why the company cannot claim to add the same to its paid-up capital for finding out the abatement allowable .... After the Indian Income-tax Act of 1922 came into force, it would be open to the company to create reserves out of allowable deduction under section 10(2) of the Indian Income-tax Act as well as out of net profits after payment of the tax. Rule 2(1) would exclude the first kind of reserves but not those of the second kind.'
18. It was this decision which was before the Supreme Court in 59 I.T.R. 685. The decision of the Calcutta High Court was affirmed by the Supreme Court, and they did not disapprove of the above remarks by the Calcutta High Court. On the other hand, it seem that in addition they pointed out that those remarks were made with special reference to the facts and circumstances of that case. Therefore, it must be taken today as settled law that the 'reserves' contemplated in rule 2 of Schedule II been not necessarily be reserves which arise our of the profits of the company and only the profits and no other source of income of the company.
19. In another decision of the Supreme Court in first National City Bank V. Commissioner of Income-tax an amount credited in the capital account of a bank was held to be a 'reserve' under rule 2 of schedule II. The first National City Bank, a non-resident bank, had following the system of accounting adopted by American banks, set aside and transferred the net profits of each year, after provision for expenses, taxes, dividends and reserves, to an account headed 'undivided profits'. The particular statute under which that allocation had been made under that account also treated 'undivided profits' as part of the capital funds of the bank. There was also evidence before the tax authorities given by the Deputy controller of Currency, Washington, that the 'undivided profits' actually represented a part of the capital fund of the bank and was included in ascertaining the adequacy of capital of the bank. When losses occurred it was the usual practice in many banks to charge them against this account of 'undivided profits' and amounts from that account were available for continuous future use in the business of the bank. The question was whether the amounts coming to the credit of the 'undivided profits' account should be treated as reserves. At page 23 of the report, the Supreme Court referred to their decision of Century Spg. & Mfg. Company's case and pointed out that the true nature and character of a sum disputed as reserve was to be determined with reference to the substance of the matter. They also approved of the statement in that case :
'...... 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 ......'
and applying that test to the disputed sum in that case they held that it cannot be said that the amount is not 'reserve' within the meaning of the rule. The tribunal in paragraph 4 of its order relied clearly upon the decision of the Calcutta High out it. Commissioner of Income-tax v. Standard Vacuum oil Co. That decision as we have said is now affirmed by the Supreme Court in : 59ITR685(SC) an for the reasons which we have stated we think that the decision of the Tribunal as regards the amounts entered in the books of the assessee as 'contribution from parties for capita expenditure' in the two chargeable accounting periods must be treated as 'reserve' within the meaning of rule 2 of Schedule II of the Business Profits Tax Act. If it is held to be a reserve it will be regard as capita within the meaning of rule 2(1), and if it is capital it will go to swell the figure of 'abatement' under section 2(1) and that turn will reduce the figure of 'taxable profits' under section 4. Accordingly, the question No. 1 must be answered in favour of the assessee, in the affirmative.
20. Then we turn to question No. 2. in the books of account of the assessee an amount of Rs. 1,55,58,441 was found credited to the works provident fund account with a note in brackets 'assets earmarked as per contra Rs. 1,52,24,220'. The amount earmarked against employees accounts came to a total of Rs. 1,52,57,331, though the total amount of the works provident fund was Rs. 1,55,58,441. Out of this amount half was the company's contribution and the other half the employees' contribution. Thus the company's contribution was Rs. 77,79,221 and the question was whether this amount should be taken into account in computing the capital of the company. The business Profits Tax Officer held that the amount of Rs. 77,79,221, must be included in the capital though the other half should be treated as moneys belonging to the employees and lying deposited in the account.
21. The latter part of sub-rule (1) of rule 2 provides that in computing the capital the figure arrived at of paid-up capital and of the reserves should be diminished by the cost to it of its investments, and one of the question was what is the amount of the investments by which the amount of the capita had to be deminished. The Business profits Tax officer held that the entire amount of the investments by which the amount of the capital had to be diminished. The assessee appealed against this part of the decision of the Business Profits Tax officer and the Appellate Assistant Commissioner affirmed the diction of the Business profits Tax Officer by observing that the rule speaks of only the investments of the company and what source test investments have benumbed had not to be examined. He, therefor, held that the Business profits Tax Officer had correctly include as the company's investments all the amounts invested against the works prudent fund account.
22. It was urged on behalf of the assessee before the Tribunal that either the provident fund and the investments should be totally ignored or if a portion of the provident fund is treated as a reserve and the rest of it not treated as reserve than far as investments are concerned, the pro rata amount of investment should not also be deducted. The Tribunal has held that in so far as the employer's contribution to the works provident fund account is concerned it was rightly held to be in the nature of 'reserve' by that so for as the balance of the amount contributed by the employees was concerned, 'it is not as if they intended that the money should belong to the assessee', and, therefore, the investments represented by that amount were not part of the investments held by the assessee for its own purposes. They found that that amount was held as a trust for the employees. The Tribunal, therefore, directed the exclusion of the investments referable to that portion of the contribution made by the employees to the provident fund.
23. The investments of the funds standing to the credit of the provident fund account is no longer left to the volition of a company. they are bound to incest these funds in certain stated securities under section 282B(2) of the Companies Act. The amount of the provident fund in the hands of the company would undoubtedly be in the nature of a trust, the amount being held for the benefit of the employees. Rule 2 speaks of the 'capital' which includes two items, namely, the paid-up share capital and the reserves in so far as they have not been allowed in computing the capital of the company. The capital thus computed taking into account the said two items has to be diminished by the cost to the assessee of its investments. Reading the rule we cannot conceive that the entire investments of the provident fund account had to be taken into account in diminishing the amount of capital to be computed while some part of the provident fund amount may not be treated as 'reserve' as in the present case. The deduction to be made in respect of investments upon a fair reading of the rule, it seems to us, must be a pro rata deduction proportionate to amount of the provident fund held to be 'reserve'. Whatever would be the amount of that part of the provident fund which is held to be 'reserve' and happens to be invested, alone can be taken into account in diminishing the capital and not the entire amount of the investments of the provident fund. Giving the rule any other interpretation would, it seems to us, derive it of all meaning and take away in a large measure that benefit which the rule confers upon the assessee in the matter of taxation. The Tribunal had in this respect taken the correct view. We answer the question No. 2 in the negative (sic). The Commissioner will pay the costs of the assessee.