1. This is a reference under section 256(1) Of the Income-tax Act, 1961, as applied to the Companies (Profits) Surtax Act, 1964, by section 18 of the latter Act. The reference has been made at the instance of the Commissioner who is the applicant before us. The assessee is Hindusthan Lever Limited. The relevant assessment years are the assessment years 1964-65 and 1965-66. The questions referred to us for determination are as follows :
2. Assessment year 1964-65 :
'Whether, on the facts and in the circumstances of the case, the following amounts were includible in the computation of capital of the assessee under rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964 : Rs.(i) Contingency reserve 12,50,000(ii) Reserve for doubtful debts 3,70,852(iii) Super profits tax reserve 16,93,354(iv) Retirement gratuity reserve 45,65,674 ?'
3. Assessment year 1965-66 :
'Whether, on the facts and in the circumstances of the case, the following amounts were includible in the computation of capital of the assessee under rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964 : Rs.(i) Contingency reserve 20,72,000(ii) Reserve for doubtful debts 10,17,481(iii) Surtax reserve 20,83,115(iv) Dividend tax reserve 7,50,000(v) Retirement gratuity reserve 48,82,698 ?'
4. The questions referred pertain to the computation of capital or capital base, as it is called, for the purpose of the Companies (Profits) Surtax Act, 1964. We propose to refer to the said Act hereafter as 'the Companies Surtax Act'. Section 4 of the Companies Surtax Act, in brief, provides that subject to the provisions of that Act, there shall be charged on every company for every assessment year commencing on and from the 1st day of April, 1964, a tax on so much of its chargeable profits of the previous year or previous years, as the case may be, as exceed the statutory deduction, at the rate or rates specified in the Third Schedule. Clause (5) of section 2, the definition section, provides, in short, that 'chargeable profits' means the total income of an assesee computed in accordance with the provisions of the Income-tax Act, 1961, for any previous year or years and adjusted in accordance with the provisions of the First Schedule to the Companies Surtax Act. The relevant part of clause (8) of section 2 provides that 'statutory deduction' means an amount equal to 10% of the capital of the company as computed in accordance with the provisions of the Second Schedule, or an amount of two hundred thousand rupees, whichever is greater. Provisos to that clause are not material for our purposes. Rule 1 in the Second Schedule to the Companies (Profits) Surtax Act provides the manner in which the capital of a company has to be calculated and it says that, subject to the other provisions contained in that Schedule, the capital of a company would be the aggregate of the amounts set out in the said Rules. These amounts include, inter alia, the paid-up share capital of the company and its reserves. It is not necessary to consider the details of the provisions of rule 1.
5. The previous year relevant to the assessment year 1964-65 is the calendar year ending December 31, 1963, and the previous year relevant to the assessment year 1965-66 is the calendar year ending December 31, 1964. The assessee is a company incorporated under the Companies Act, 1956. The Income-tax Officer concerned arrived at the total capital employed by the assessee for each of the said assessment years by aggregating the paid-up capital of the assessee, the development rebate reserve, the general reserve and the money borrowed for the purposes of the business of the assessee. In the computation of the said capital, the Income-tax Officer declined to include the following for arriving at the standard deduction :
1964-65 1965-66Rs. Rs.(i) Contingencies reserve 12,50,000 20,72,000(ii) Reserve for doubtful debts 3,70,852 10,77,481(iii) Super profits tax reserve 16,93,354(iv) Surtax reserve 20,85,115(v) Dividend tax reserve 7,50,000(vi) Retirement gratuity reserve 45,65,674 48,82,588
6. The contention of the assessee that the said amounts were in the nature of reserves was negatived by the Income-tax Officer by relying on the Explanation to rule 1 of the Second Schedule to the Companies Surtax Act and items (5), (6) and (7) under the heading 'Reserves and Surplus' in the form of balance-sheet prescribed in the Sixth Schedule to the Companies Act, 1956. The assessee preferred appeals against the assessment orders passed by the Income-tax Officer in respect of the said assessment years. The Appellate Assistant Commissioner hearing the said appeals held that the amount of retirement gratuity reserve would have to be included in the capital computation and, as regards the other amounts, relying on the Explanation to rule 1 of the Second Schedule to the Companies Surtax Act and the definitions of the expressions 'reserve' and 'provision' in Part III of the Sixth Schedule to the Companies Act, he came to the conclusion that the other items of contingency reserve, reserve for doubtful debts and super profits tax, surtax and dividend tax reserve for each of the years under consideration were 'provisions ' and not 'reserves'. Both the assessee and the Revenue preferred appeals to the Tribunal against the order of the Appellate Assistant Commissioner. Both these appeals were consolidated and heard together and disposed of by a common order of the Tribunal from which this reference has arisen. For the reasons set out in paragraphs 6 to 14 of its order, the Tribunal held that the aforesaid reserves, namely 'contingency reserve' and 'reserve for doubtful debts', for each of the years under consideration and 'super profits tax reserve' for the assessment year 1964-65 and 'surtax reserve' and 'dividend tax reserve' for the assessment year 1965-66 as also the 'gratuity reserve' for each of the two years under consideration were, in fact, 'reserves' and not 'provisions', with the result that the same would have to be included in computing the capital of the company for the purpose of arriving at the standard deduction. The questions set out earlier have been referred to us from this decision of the Tribunal.
7. Before setting out the arguments of the counsel, we may note that the Explanation to rule 1 of the Second Schedule to the Companies Surtax Act provides that any amount standing to the credit of any account in the books of the company on the date set out therein which is of the nature of items (5), (6) or (7), under certain headings in the column relating to 'Liabilities' in the 'Form of balance-sheet' given in Part I of the Sixth Schedule to the Companies Act shall not be regarded as a reserve for the purposes of computation of the capital of a company for the purposes of that Second Schedule. It is not necessary to set out the said Explanation in further detail because it is common ground that where an amount is set apart by way of a 'provision', it cannot be regarded as a reserve or included in the computation of the capital of the company for the aforesaid purposes. Before going into the details of the items set out in the questions, we might refer to the leading decision of the Supreme Court in this connection in the case of Vazir Sultan Tobacco Co. Ltd. v. CIT : 132ITR559(SC) because all the questions which arise in this case, it is common ground, must be decided in the light of the principles laid down in that decision. The Supreme Court in that judgment has pointed out that the expression 'reserve' has not been defined in the Super Profits Tax Act, 1963, or the Companies (Profits) Surtax Act, 1964. Though the expression 'reserve' is not defined, since it occurs in taxing statutes applicable to companies only and to no other assessable entities, the expression has to be understood in its 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 the words 'reserves' and 'provisions' in the Companies Act, 1956, dealing with the preparation of the balance-sheet and the profit and loss account would govern their construction for the purposes of the two enactments. The broad distinction between the two is that whereas a 'provision' is a charge against the profits to be taken into account against gross receipts in the profit and loss account, a 'reserve' is an appropriation of profits, the asset or assets by which it is represented being retained to form part of the capital employed in the business. The question whether the concerned amounts constitute 'reserve' 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. The true nature and character of the appropriation must be determined with reference to the substance of the matter; this means that one must have regard to the intention with which and the purpose for which the appropriation has been made, such intention and purpose being gathered from the surrounding circumstances. The following aspects provide some guidelines :
(a) a mass of undistributed profits cannot automatically become a reserve and somebody possessing the requisite authority must clearly indicate that a portion thereof has been earmarked or separated from the general mass of profits with a view to constituting it either a general reserve or a specific reserve;
(b) the surrounding circumstances should make it apparent that the amount so earmarked or set apart is in fact a reserve to be utilised in future for a specific purpose and on a specific occasion; and
(c) a clear conduct on the part of the directors in setting apart a sum from out of the mass of undistributed profits avowedly for the purpose of distribution as dividend in the same year would run counter to any intention of making that amount a reserve.
8. Coming first to the question of retirement gratuity reserve, it is common ground that this question has to be decided in accordance with the aforesaid decision of the Supreme Court. The Supreme Court in Vazir Sultan Tobacco Co.'s case : 132ITR559(SC) held that ordinarily an appropriation to gratuity reserve will have to be regarded as a provision made for a contingent liability, for, under a scheme 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. It has been pointed out that the amount of gratuity payable is usually dependent on the employee's wages at the time of determination of his employment and the number of years of service put in by him and the liability accrues and enhances with the completion of every year of service, but the company can work out on an actuarial valuation its estimated liability (that is, 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 clause 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. However, if the sum so appropriated is shown to be in excess of the sum required to meet the estimated liability, being the discounted present value on a scientific basis, it is only the excess that will have to be regarded as a reserve. In the case before us, in the relevant previous years relevant to both assessment years in question, the assessee company set apart certain amounts on account of gratuity liability, as the assessee appears to have done, merely to add lump sum amounts to the amount already there in the said reserves. It is common ground, therefore, that in respect of gratuity reserve, the case will have to be referred back to the Tribunal to calculate as to whether there is any excess in the amounts set apart for the aforesaid purpose by the company on the deduction from the same of the aggregate estimated gratuity liability, and it is only that excess which can be included in the computation of the capital for the purpose of determining the standard deduction. Neither counsel has disputed that this would be the correct position. It is, of course, true that the aggregate estimated liability will have to be calculated in accordance with law and the principles of accountancy applicable in the matter.
9. Coming to the next item of contingency reserve, it seems that amounts have been set aside in both the relevant previous years to meet possible demands for excise duty and sales tax. In the previous year relevant to the assessment year 1964-65, the amount set aside was Rs. 12,50,000, and this reserve was set aside to meet possible demands for excise duty and sales tax, the amount set aside on account of a possible demand for excise duty being Rs. 11,00,000 and that set apart on account of a possible demand for sales tax was Rs. 1,50,000. It was not that the assessee felt that these amounts would be demanded on a proper interpretation of the law but merely felt that the amounts should be set aside in case such demands were made on possible adverse interpretation of certain notifications and even to meet demands unwarranted by law. No assessment was ever made in this regard and no liability accrued. The position in the next assessment year was similar. There is, therefore, no dispute that these amounts should be included in the computation of the capital of the company for the aforesaid purposes.
10. As far as the amounts set aside or reserve created so far as the super profits tax liability is concerned in respect of the assessment year 1964-65, according to Mr. Dastur, the amount of Rs. 16,93,354 referred to in item No. (iii) is the amount by which the amount set aside for this purpose exceeded the liability ascertained on account of the super profits tax payable. Similarly, in respect of the assessment year 1965-66, according to Mr. Dastur, the amount of Rs. 20,83,115 in surtax reserve referred to in item No. (iii) represents a similar excess over the actual liability. Mr. Dhanuka, however, states that he is not in a position to state whether what Mr. Dastur states is correct and that the Tribunal should be directed that when the matter goes back to it, the Tribunal must calculate the correct liability of the assessee for super profits tax in the assessment year 1964-65 and for surtax in the assessment year 1965-66 and include in the computation of the capital of the assessee company only the excess amounts in these reserves. There seems to be no objection to this course of action being followed and the Tribunal is directed accordingly.
11. As far as the amounts set aside by way of reserves for doubtful debts in both the said assessment years are concerned, there is no controversy either. The facts found in the decision of the Tribunal show that the undisputed factual position was that these reserves were created to cover all debts over six months old and no attempt was made to estimate which of these debts would really become bad debts. The said reserve was thus not created by the assessee on account of any possibility of debts becoming bad. In fact, there are hardly any doubtful debts in the case of the assessee. In view of these facts, it is common ground that the amount set apart by way of reserves for doubtful debts in respect of the said two assessment years have to be included in the computation of capital of the assessee for the aforesaid purposes.
12. We finally come to the question of the dividend tax reserve. This reserve appears in the question relating to the assessment year 1965-66. In this regard, the facts which have to be borne in mind are that the accounting year relevant to this assessment year ended on December 31, 1964. On January 1, 1964, there was no law in force imposing any tax on dividend nor had any Bill for imposing such a tax been introduced in Parliament. The Bill for imposing such a tax was introduced in Parliament on February 29, 1964, and the Finance Act imposing tax on dividends came into effect on April 28, 1964. The actual liability on account of dividend tax which has been imposed on the assessee is Rs. 7,41,924. So, the excess amount in this reserve comes to Rs. 7,50,000 minus Rs. 7,41,924. It was submitted by Mr. Dhanuka that as far as the reserve created for the payment of dividend tax is concerned, it represented fairly accurately the amount payable by the assessee on account of dividend tax and hence when the amount of Rs. 7,50,000 was set aside to meet that liability, it was on a fairly accurate estimate and is in the nature of a provision. The intention in setting aside that amount, according to Mr. Dhanuka, was to set aside an amount on a fairly accurate basis of what would be the liability on account of the dividend tax. It was urged by him that the question of intention of the assessee in setting apart the amount was the material factor in determining the nature of that amount and the mere fact that the actual liability for payment of dividend tax came to a slightly smaller figure would make no difference and no part of that amount could be included in the computation of the capital of the assessee. It was, however, fairly conceded by him that, looking to the smallness of the difference between the amount set apart and the amount the assessee has been held to be liable to pay on account of dividend tax, it would be in order if the excess amount were directed to be included in the computation of the capital of the company. It was, however, urged by Mr. Dastur in connection with the aforesaid amount that on January 1, 1964, there was no Act in force imposing any tax on dividend nor had any Bill been introduced for the purpose and it was not in the contemplation of the directors that any such liability would be imposed on the assessee. It was pointed out by him that under the provisions of rule 1 of the Second Schedule to the Companies Surtax Act, the capital of the company has to be calculated as on the 1st day of the previous year relevant to the assessment year, which in this case would be January 1, 1964. It was submitted by him that in view of this, the entire amount of Rs. 7,50,000 was liable to be included in the capital of the company. It was pointed out by him that in this connection, we have to bear in mind that it is an admitted fact that these reserves were not created on or before January 1, 1964, but during the calendar year 1964. Mr. Dastur relied on the decision of the Supreme Court in CIT v. Mysore Electrical Industries Limited : 80ITR566(SC) . In that decision, the Supreme Court has pointed out that it is well known that the accounts of the company have to be made up to a particular date. In the case before the Supreme Court, that day was March 31, 1963. If the accounts could have been reasonably made up on that date, the directors could have made up their mind on appropriating various amounts for reserves, but it is practically impossible in any case to make up the accounts of a company on the very next day (after the end) of the accounting year. It was held that the determination to appropriate the sums mentioned earlier in the judgment to the three separate classes of reserves on August 8, 1963, must be related back to April 1, 1963, that is, the beginning of the accounts for the new year, and must be treated as effective from that day. There is no doubt about the correctness of the principles laid down in this decision. Applying those principles, although in the present case, the amount of Rs. 7,50,000 was set apart much later than January 1, 1964, we may note here that it was on March 24, 1964, after the aforesaid Bill was introduced in Parliament, that the directors recommended the setting apart of that amount and the accounts were finalised actually setting apart the amount or making the appropriation on April 20, 1964, at the annual general meeting of the shareholders of the company. However, as pointed out earlier, the setting apart of the amount must be related back to January 1, 1964, and it would be illogical to say that the setting aside of the amount must be related back, but not the intention and the purpose for which it was set aside. The amount was set aside actually on April 24, 1964. By that date, the Finance Act imposing tax on dividends had already come into force, and, therefore, it is beyond dispute that this amount was set aside in order to meet the liability to pay tax on dividend which came into existence on account of the provisions of the Finance Act. As to when that liability would be quantified is a different question. In our view, therefore, Mr. Dastur's contention that the entry in the account of Rs. 7,50,000 should be included in the capital on this ground cannot be accepted. In this regard, we may refer to the decision of a Division Bench of the Calcutta High Court in Braithwaite & Co. (India) Ltd. v. CIT : 111ITR825(Cal) . The question in that case also was in respect of computation of capital for the purpose of the Companies Surtax Act. The Division Bench considered the decision of the Supreme Court in the case of Mysore Electrical Industries Ltd. : 80ITR566(SC) , and pointed out (p. 839) that a company is entitled in law to finalise as to what was the position of its accounts up to a particular date at a later point of time. A company can similarly finalise its appropriations for various purposes, including reserves and provisions, at a later date with retrospective effect. Such determination to appropriate must be related back to the date up to which the accounts are finalised and must be treated as being effective from that date. They further held that once such determination and appropriation are made, they finally determine the character of the allocation and if it relates back to an earlier point of time, then it relates back effectively in all respects and retains its nature and character. A company can take the advantage of the retrospective effect of its determination of appropriation, but it cannot then contend that by being retrospectively effective, the nature of the appropriation will change. This decision, with which we are in respectful agreement, lends considerable support to the view which we have taken.
13. Finally, it was pointed out by Mr. Dastur that the liability to pay the amount of Rs. 7,41,924 imposed as dividend tax had been imposed on the footing that the assessee was a company in which the public was substantially interested. That conclusion has been arrived at by this court in appropriate proceedings. It was pointed out by him that in case this finding is reversed by a higher court, the result would be that the assessee would not be liable to pay any dividend tax at all, although it would incur a larger income-tax liability. It was submitted by him that in that eventuality the entire amount of Rs. 7,50,000 will have to be added in the computation of the capital of the company. Mr. Dastur is undoubtedly right as to the consequences which would follow in the event of the aforesaid conclusion of the High Court being reversed, because, in that event, it could not even be said that Rs. 7,50,000 was an accurate estimate of the liability on account of the dividend tax.
14. In the result, the questions referred to us are answered as follows :
Items Nos. (i) and (ii) of the questions in respect of both the assessment years :
Answers : These amounts will have to be included in the computation of the capital for the purposes set out in the questions.
Item No. (iii) in questions relating to both the assessment years :
Answers : The Tribunal will have to determine whether the amounts set out in these items represent excess of the amounts set apart for the respective purposes over the tax liability on account of super profits tax and surtax, respectively, in the relevant years and to the extent that there is such an excess but not exceeding the amounts stated in the respective items, it will be included in the capital of the company.
Items Nos. (iv) and (v) of the questions relating to respective assessment years (retirement gratuity reserve).
Answer : The Tribunal will determine as to what is the amount of the estimated liability of the assessee on this account and if the amounts set apart for retirement gratuity reserve are in excess of such estimated liability to that extent, they will have to be added in the computation of capital of the assessee. It is clarified that the estimated liability will have to be determined by the Tribunal in accordance with law and the principles of accountancy applicable in the matter.
15. As regards dividend tax reserve (item (iv) in the question relating to the assessment year 1965-66), the amount of Rs. 8,076 has to be added in the computation of the capital of the company for the purpose referred to in the question. In the eventuality referred to by Mr. Dastur, set out in page 711 (supra), the entire amount of Rs. 7,50,000 will have to be added to the capital of the company for the said purposes.
16. The Tribunal will compute the capital of the assessee for the aforesaid purposes, in accordance with this judgment, when the matter goes to the Tribunal without waiting for any decision on the question as to whether the assessee is a company in which the public is substantially interested.
17. Looking to all the facts and circumstances of the case, there will be no order as to costs.