1. This is a reference under section 66 (1) of the Indian Income-tax Act, 1922.
2. This reference concerns the assessment year 1956-57, the corresponding accounting year being the year ended on 31st March, 1956.
3. The assessee is an individual. During the accounting year the assessee was a registered holder holding 11 shares of the Malegaon Electricity Company P. Ltd., hereinafter referred in as 'the Malegaon Electricity Company', out of a total of 845 shares issued by the company. The assessee held those 11 shares as a nominee of the Consolidated Electric Agencies Ltd. The latter company was the managing agent of the Malegaon Electricity Company. During the accounting year the Malegaon Electricity Company advanced to the assessee a loan of Rs. 4,16,000. The balance-sheet of the Malegaon Electricity Company for the year ended 31st March, 1956, shows that it had in its general reserve fund a sum of Rs. 80,000 and in its profit and loss appropriation account a profit of Rs. 2,91,603-0-8. The Income-tax Appellate Tribunal held that these two amounts of Rs. 80,000 and Rs. 2,91,000 odd represented the accumulated profits of the Malegaon Electricity Company at the relevant time. The Tribunal held that in views of the accumulated profits the loan by the Malegaon Electricity Company to the assessee would attract the provisions of the section 2 (6M) (e) and would be liable to be deemed to be dividend to the extent of such accumulated profits. The Malegaon Electricity Company had advanced a loan during this accounting year to its another shareholder and that loan also was treated as deemed dividend. By reason of appointment of the amounts of these two loans which were deemed to be dividends, the Tribunal held that a sum of Rs. 2,83,126 out of the loan to the assessee of Rs. 4,16,000 must be treated as dividends under section 3(6A) (e).
4. Before the Tribunal the assessee had raised certain contentions and so had the department, and in view of those contentions the following questions of law have been referred. The questions are :
'1. Whether section 2 (6A) (e) of the Income-tax is ultra vires the Constitution of India
2. Whether, on the facts and in the circumstances of the case, the loan by the company to the assessee was liable to be included in the total income of the assessee as dividend under section 2 (6A) (e) if the Income-tax Act
3. If the answer to the second question is in the affirmative, whether, on the facts and in the circumstances of the case, the amount of Rs. 64,000 being the value of fully paid up shares issued to the promoters without consideration in 1934 could be deducted in determining the accumulated profits for the purpose of section 2 (6A) (e)
4. If the answer to the second question is in the affirmative, whether on the facts and in the circumstances of the case, the Income-tax liability of the company which was in dispute and which was not provided for in the books of the company was liable to be deducted in determining the accumulated profits for the purpose of section 2 (6A) (e) ?'
5. The balance-sheet of the Malegaon Electricity Company as at 31st March, 1956, has been annexed as annexure 'A' to the statement of the case and forms part of it. On the 'capital and liabilities' side of the balance-sheet the issued and subscribed capital is shown at Rs. 84,500, the general reserve fund at Rs. 80,000, the aggregate of its liabilities at Rs. 2,27,810-2-4 and the profit and loss appropriation account at Rs. 2,91,603-0-8. No other Items appear on the capital and liabilities side. What is pertinent to note is that this balance-sheet shows that the Malegaon Electricity Company did not maintain in its balance-sheet a depreciation account or depreciation fund separately. It was mentioned before us by counsel on both sides that in the assessment of the income, profits and gains of the Malegaon Electricity Company certain depreciation was allowed by the income-tax authorities from 1936, when the Malegaon Electricity Company started functioning, on the basis of the rates provided for under the Indian Income-tax Act, 1922. The Malegaon Electricity Company is an electricity company and after the enactment of the electricity supply Act, 1948, it was governed by the provisions of that Act. For the purpose of making certain calculations under that Act the Malegaon Electricity Company was allowed depreciation on its capital assets at a certain rate which was lower than the rate for depreciation allowed to it under the Income-tax Act. The Malegaon Electricity Company's balance-sheets have all along been prepared on the basis of the depreciation allowance calculated as under the electricity Supply Act, 1948. The result has been that the provision in the said balance-sheet for the general reserve fund and the amount shown as profit in the profit and loss appropriation account do not correctly represent the position of the Malegaon Electricity Company in so far as the amount for depreciation as calculated under the Income-tax Act has not been reflected therein. Under the provisions of section 2 (6A) (e), a loan is to be deemed to be a dividend only to the extent that the company possesses accumulated profits. It was, therefore, necessary to ascertain what was correct amount of accumulated profits in the possession of the Malegaon Electricity Company at the time relevant to this assessment year. This material, however, is not available from the statement of the case or any other documents annexed thereto and forming part thereof. Both counsel, however told us that the necessary material will be on the record of the Tribunal and if felt it necessary, we should call for supplemental statement of the case annexing all the relevant documents. As the parties, however, wanted to consider the position, we adjourned the matter for a few days and thereafter the parties handed in three statement which we have marked as exhibits 'E', 'F'and 'G', respectively, and the parties have stated that they are agreed that these statements have been prepared from the documents on the record of the Tribunal and correctly reflect the position emerging from these documents. The parties have thereby eliminated the necessity for this court calling for a supplemental statement of the case, because all that the supplemental statement of the case would have done was forward copies of the documents already on the record of the Tribunal. We will, therefore, proceed on the basis of these three statements which the parties have compiled by consent and have agreed that they should form part of the case already before us.
6. These statements show that if the basis for depreciation is the rates of depreciation allowed under the Electricity Supply Act which have actually been used for compiling the relevant balance-sheet of the Malegaon Electricity Company the sum of Rs. 80,000 in the company's general reserve fund and the sum of Rs. 2,91,603-0-8 shown as profit in the profit and loss appropriation account would represent the accumulated profits of that company at the relevant time. But if the basis of the depreciation is taken at the rates allowable under the Income-tax Act and in fact taken into consideration in the assessment of that company for all the years ever since its inception, it would be clear that the company's profits were inadequate in many of the years, with the result that at the relevant time not only there were no accumulated profits whatever, but there was, as matter of fact, a sum of Rs. 7,697 to be carried forward as unabsorbed depreciation available for a set-off against profits of subsequent years. In view of these two conflicting results yielded by the depreciation actually taken in consideration by the Malegaon Electricity Company in its balance-sheets on the one hand and by the actual assessment orders made by the income-tax authorities from the very inception of that company on the other, the question arises as to what is the correct method of determining 'accumulated profits' under section 2 (6A) (e) and, if there are any accumulated profits so determinable, what is the correct amount thereof.
7. Now, 'accumulated profits' signifies, firstly, that there must have been profits in years, and secondly, that amounts out of such profits have been accumulated from time to time, with the result that there is some amount of accumulated profits in the possession of the company just before the commencement of the accounting year in this reference. That entails a determination as to what is the meaning of the words 'Profits' in the phrase 'accumulated profits'. The latter determination is in this case an easy one because it involves no consideration other than that as to depreciation. It is not disputed on either side that for the purpose of arriving at profits the amount of depreciation must be deducted from gross profits. The only dispute is what is the amount of depreciation to be allowed in the present case.
8. Mr. Joshi, the learned counsel for the department, contended that the Malegaon Electricity Company has, as a matter of fact, calculated the depreciation in preparing its balance-sheets on the basis of the depreciation allowable and allowed under the Electricity Supply Act and that that is the only basis on which the accumulated profits should be calculated in this case. He contended that it is not permissible to go behind its balance-sheets over so many years and recalculate depreciation on any other basis. He contended that the Malegaon Electricity Company has not maintained a separate depreciation fund and, therefore, the amounts as appearing in its balance-sheet, in its general reserve fund and in the profit and loss appropriation account be taken as the accumulated profits of that company. In our opinion, this would not be the correct method of ascertaining the accumulated profits of the Malegaon Electricity Company. Profits for the purpose of ascertaining accumulated profits must be determined after allowing depreciation allowable and allowed under the Income-tax Act. Section 2 (6A) (e) creates a fiction. That fiction has been created for the purpose of the Income-tax Act. By that fiction a loan which in reality is not a dividend is to be deemed a dividend and would become liable to be brought to tax in the hands of the shareholder to whom the loan has been advanced. It is an artificial creation of liability and it is created by Income-tax Act. The words, therefore, used in that section must be construed in the sense in which they have been used in the Income-tax Act and calculations must be made on the basis contemplated by the Income-tax Act. It would not be permissible to feed the fiction with material outside the Income-tax Act itself. Now depreciation is to be deducted from gross profits, because the amount of depreciation is to be set apart to replace the capital which is lost by the reason of the normal wear and tear of machinery, plant and like assets. Unless such depreciation is set apart, the gross profits will contain an element within them which is really of a capital nature. If the gross profits are treated as profits without provision of any depreciation, at the end of the useful life of the asset they will be lost completely. It is to for replacement of the capital assets so lost by reason of normal wear and tear that depreciation is allowed, so that at the end of the useful life of those assets a fund is available to replace those assets. In short, a provision for depreciation is of a capital nature and is intended to replace the capital which is lost by wear and tear. Now, the Income-tax Act does make a provision for allowing depreciation as a deduction, for example, under section 10 (2) (vii). In our opinion, therefore, for the purpose of calculating profits within the meaning of the phrase 'accumulated profits' under section 2 (6A) (e), an allowance of depreciation should be made by way of a deductions at the rates provided for by the Income-tax Act itself. It may be that in some cases a difficulty may arise in applying this principle, which is of a general application, if any assessee has not maintained its balance-sheets or account on the basis of the rates of depreciation allowable and allowed to him under the Income-tax Act, but on some different basis because of want of the necessary material to ascertain what threw actual depreciation actual depreciation allowed to the assessee under the Income-tax Act was. Fortunately, in the case before us, no such difficulty arises and, as a matter of fact, as stated earlier, the parties have agreed upon the three statements which they have now put in. These statements clearly show, not only that the Malegaon Electricity Company did not at the relevant time have any accumulated profits Whatever, but that, on the contrary, immediately before the accounting year under consideration, there was an amount of Rs. 7,697 to be carried forward, as unabsorbed depreciation for want of adequate profits. It is, therefore, quite clear that at the relevant time the Malegaon Electricity Company did not possess any accumulated profits whatever and the question of the application of the section 2 (6A) (e) and considering whether the loan was advanced by the Malegaon Electricity Company to the assessee does not arise at all.
9. We may record that it had been contended on behalf of the assessee, in the alternative, that the loan under section 2 (6A) (e) must be a loan to that person in whose hands the income from the declared dividends would be assessable, but that it is the assessee's case that tough the assessee was the registered holder of the said II shares, he held them merely on behalf of the Consolidated Electric Agencies Ltd., and that the declared dividends would in law be assessable only in the hands of the latter company as the beneficial holder thereof and that the loan advanced to the assessee would not, therefore, attract the provisions of section 2 (6A) (e). In view of the fact, however, that the Malegaon Electricity Company was not in possession at the relevant time of any accumulated profits whatsoever, this alternative argument becomes unnecessary for our consideration and we, therefore, do not consider the same.
10. Our answers to the questions are as follows :
Q No. 1. - The Supreme Court by its judgment in the Navnit Lal C. Javeri V. K. K. Sen, Appellate Assistant Commissioner of Income-tax already held that section 2 (6A) (e) is not ultra vires the Constitution of India. The question, therefore, does not survive for our determination and answer and, we, therefore do not answer the same.
Q. No. 2. - In the negative.
Q. No. 3 and Q. No. 4 - Do not arise or survive for our consideration and answer, in view of our answer to question No. 2 being in the negative.
11. The department to pay the assessee's costs.