1. The question that falls for consideration in the present reference relates to the computation of the capital base of the assessee under the Super Profit Tax Act, 1963 (hereinafter referred to as 'the Act'), and the precise question is whether secret reserves maintained by the assessee-bank are includible in the capital of the assessee.
2. The assessee is a banking company and the assessment year is 1963-64 when the Act was applicable to the assessee. The computation of the super profits tax is to be made in accordance with the rules given in the Act. The rules contained in Sch. II to the Act provide for the computation of the capital base which computation is necessary for arriving at the standard deduction. The profits which are in excess over the standard deduction are only liable to super profits tax. Hence, the computation of standard deduction assumes significance.
3. The assessee-bank computed its capital for the purposes of calculating super profits tax, and in doing so it took into consideration the following items as constituting its reserves, viz., (1) Rs. 76,58,687 which represented the amount standing to the credit of the premium and discount account but which was not shown in its balance-sheet; (2) Rs. 1,31,00,548 being the taxation reserve; and (3) Rs. 85,84,302 which were the depreciation reserve.
4. It is common ground that the first amount of Rs. 76,58,687 did not figure in the published balance-sheet of the bank and this was stated to be the amount merged in investment shown in item (4) of the balance-sheet for the assessment year in question, viz., 1963-64, would be the balance-sheet as on December 31, 1962, in relation to the calendar year 1962, which is the accounting year followed by the assessee-bank. However, since for super profits tax we are concerned with the first day of the previous year for the computation of capital, it is necessary to look into the figures in the balance-sheet relating to the year prior to the previous year and hence we are concerned with the balance-sheet as on December 31, 1961.
5. The said investment in the balance-sheet showed a sum of Rs. 22,24,12,868.18 under the head 'Security and share accounts'. A break up of this figure was produced before the Tribunal to show how the amount of Rs. 76,58,687 was made up. The said break-up is as follow :
Rs.Debit balance of security and share account. 23,00,71,555.37Les : Credit balance of premium and discount balance. 76,58,687.19----------------22,24,12,868.18----------------
6. The ITO negatived the claim with regard to this amount as reserve on the ground that the said reserve was not created by the requisite authority.
7. With regard to the taxation reserve of Rs. 1,31,00,548, the ITO took the view that only the excess over the known liability should be considered as reserve. According to him, the said excess was Rs. 39,33,579, and allowed only the said sum as reserve. The difference between Rs. 1,31,00,548 and Rs. 39,33,579 was the amount in dispute. The ITO however, by mistake, has stated in his order that the claim for taxation reserve was for a sum of Rs. 1,22,28,421. The AAC in appeal correctly took the sum as Rs. 1,31,00,548. Hence, the amount in dispute was Rs. 91,66,969 and not Rs. 39,33,579 (which was allowed by the ITO as a reserve) on the basis of the correct figure as taken by the AAC at Rs. 1,31,00,548.
8. As regard the depreciation reserve, the ITO has held that the inclusion or depreciation reserve could not be allowed since the bank had no reserve as such but had only claimed the amount written off from the various assets after the deduction of depreciation therefrom as reserve. Though the amount mentioned was Rs. 85,84,302 before the ITO and the AAC and at the time of the hearing of this appeal before the Tribunal, at the time of the application for making a reference it was admitted that the correct claim was only to the extent of Rs. 69,03,280 under this head.
9. Against the order of the ITO, the assessee-bank preferred an appeal and in the appeal the AAC confirmed the finding of the ITO with regard to all the three amounts. The assessee carried the matter further in appeal to the Tribunal. With regard to the first amount, the Tribunal took the view that the said amount constituted moneys kept available for the use of the bank and though this account was not styled as reserve, was kept to meet some eventualities and, therefore, it could be treated on par with the reserve for contingency. The Tribunal further accepted that there may not be an express authorisation of the Board on this account and in this connection observed that a decision regarding a secret matter of this nature could not be taken by an executive action; the matter being a vital and a crucial one the decisions would rest with the Board alone and it alone could take and assume responsibilities in that behalf. The Tribunal, therefore held that such a reserve must have been created with the requisite authority from the board of directors though the evidence of such authority was not available. The Tribunal also took the view that the transfers to the said account could not be made by an express act of authority as in the case of other appropriation which were brought to the notice of the shareholders and the members of the public. The Tribunal, therefore, held that the said premium and discount account was reserve and, therefore, was eligible to be considered as capital base for the computation of capital base under the Act. As regards the taxation reserve, the Tribunal took the view that it was a provisions and not a reserve. As regards the third amount of depreciation, the Tribunal felt that he very existence of such reserve was not proved to the hilt and, therefore, the view taken by the AAC and the ITO in the matter could not be disturbed.
10. The revenue thereafter made an application to the Tribunal for a reference under s. 256(1) of the I.T. Act, 1961, read with s. 19 of the Act and at the hearing of the said reference application with regard to the Tribunal's finding that the said amount of Rs. 76,58,687 was includible in the computation of the capital base of the assessee, the assessee raised two questions, viz., one relating to the non-inclusion of the taxation reserve and the other with regard to the non-inclusion of the depreciation reserve for the computation of its is capital base. The Tribunal, relying on a decision of this court in Girdhardas & Co. Ltd. v. CIT : 31ITR82(Bom) , held that although the assessee had not made a separate application of its own to make a reference of the said two question to the Tribunal, the Tribunal was empowered to refer the question raised by the assessee also, along with the question sought to be referred by the Revenue. Hence, the Tribunal made a reference of the following three question to this cour :
'(i) Whether, on the facts and in the circumstance of the case, it has been rightly held that the sum of Rs. 76,58,687 being the amount standing to the credit of the premium and discount account was a reserve to be added to the capital under rule 1 of the Second Schedule to the Super Profits Tax Act ?
(ii) Whether, the facts and in the circumstances of the case, it has been rightly held that out of the sum of Rs. 1,31,00,548 standing to the credit of the taxation reserve account as on January 1, 1962, the amount of the known tax liability did not constitute a reserve for the purposes of rule 1 of the Second Schedule of the Super Profits Tax Act ?
(ii) Whether, on the facts and in the circumstances of the case, it has been rightly held that to the extent of the sum claimed by the respondent in respect of the excess depreciation provided over the income-tax depreciation as depreciation reserve it did not constitute a reserve for the purposes of rule 1 of the Second Schedule of the Super Profits Tax Act ?'
11. It is now conceded by Shri Dastur appearing for the assessee that in view of the decision of the Supreme Court in CIT v. Damodaran : 121ITR572(SC) , the last two question could not have been referred by the Tribunal in an application for reference by the revenue. Hence, it is not necessary for us to answer the said two question. As stated earlier, therefore, the question that falls for consideration in this case is whether the Tribunal was right in its view that the said amount of Rs. 76,58,687 representing the balance standing in the published balance-sheet of the assessee-bank could be treated as a reserve and included in the capital base for the purposes of calculation of excess profits under the Act, viz., the S.P.T. Act, 1963.
12. Admittedly, the assessee-bank has been treating this amount as what is called a secret reserve and, as has been stated earlier, it was not shown in the published balance-sheet for the relevant year. It is also not disputed that there is no record of the authority to authorise the appropriation of the said amount to the said secret reserve account. Not only that, the amount does not appear in so many figures anywhere and it has to be inferred from the relevant entire in the balance-sheet. The entries in the balance-sheet also further would not indicate any particular amount as being on account of the profits and loss incurred due to the sale of the shares or securities since the amount standing to the said account at any particulars point of time does not constitute entirely of the said amount but also consists of amounts appropriated from time to time from the profits and loss account. Accounting to the assessee, further, the said amount which is shown under the premium and discount account represents the balance standing to the credit of the said account on the first day of the previous year which is the relevant day of accounting purposes and all the profits and losses made on account. According to the assessee, the bank enjoys certain privileges under which it could withhold certain information from the published balance-sheet in the interests of healthy banking practice and, therefore, this account could not form part of the balance-sheet; but the books of account did show the said amount. They were in the nature of hidden reserves and it was not disputed that the said funds were utilised and employed in the business. According to the assessee, no requisite appropriation would be necessary for an account of this type as there was a continuous and implied authority for appropriation in view of the special privileges enjoyed by a bank. It was, therefore, submitted before the Tribunal that all the transfers could be done without the requisite authority.
13. As against this, it was the contention of the revenue that it would lead to absurd if all such items claimed by the bank were considered as reserves and this would results in capital base becoming so large that no super profits would ever arise. The revenue, therefore, insisted that the capital employed should be strictly construed and only that amount should be allowed to be computed as capital which was expressly permitted by the rules under the Act.
14. Before we deal with the relevant controversy, it will be necessary first to refer to the provisions of the Act in that behalf. Under s. 4 of the Act, there shall be charged on every company for every assessment year commencing on and from April 1, 1963, a tax, called the super profits tax, in respect of so much of its 'chargeable profits' of the previous year as exceed the 'standard deduction', at the rate or rates specified in the Third Schedule. Section 2(5) defines the expression 'chargeable profits' to mean the total, income of an assessee computed under the I.T. Act, 1961, for any previous year and adjusted in accordance with the previsions of the First Schedule. Section 2(9) defines the expression 'standard deduction' to mean an amount equal to six per cent. Of the capital of the company as computed in accordance with the provisions of the Second Schedule, or an amount of fifty thousand rupees, whichever, is larger. In order to determine 'standard deduction' it becomes necessary to compute the capital of the company in accordance with the rules laid down in the Second Schedule, and r. 1 which is relevant for our purposes, so far as it is material, is as follow :
'1. Subject to the other provisions contained in this Schedule, the capital of a company shall be the sum of the amounts, as on the first day of the previous year relevant to the assessment year of its paid up share capital and of its reserve, if any, created under the proviso (b) to clause (vib) of sub-section (2) of section 10 of the Indian Income-tax Act, 1922, or under sub-section (3) of section 34 of the Income-tax Act, 1961, reserves have not been allowed in computing its profits for the purposes or the Indian Income-tax Act, 1922, or the Income-tax Act, 1961....'
15. Thus, it is clear from the aforesaid provision of r. 1 that before any amount qualifies for inclusion in the capital computation of a company two conditions should be fulfilled : (1) that the amount must be a 'reserve', and (2) the same must not have been allowed in computing the company's profits for the purposes of the I.T. Act, 1922, or the I.T. Act, 1961. It is not disputed that the present amount had not be allowed in computing the assessee's profits under the 1961 Act. Therefore, the second condition has been satisfied. The only question that requires to be answered is whether the said amount falls within the expression 'reserve' occurring in the Rules and satisfies the first condition.
16. What a reserve is has been explained by this court in its decision in the case of Shree Ram Mills Ltd. v. CIT : 108ITR27(Bom) . The sum and substance of the law laid down by this court in that behalf is that if the amount set aside is not designed to meet a liability, contingency, commitment or diminution in the value of the assets known to exit at the date of the balance-sheet, it will qualify itself to be called a reserve. There is no definition of reserve given under the Act, and, therefore, the general definition of reserve will have to be made applicable for finding out whether the amount in question falls in the said category. Two more decisions will have to be referred to in this connection. They are a decision of the Supreme Court in CIT v. Century Spinning and . : 24ITR499(Bom) and a later decision of the Calcutta High Court in Indian Steel and Wire Products Ltd. v. CIT : 27ITR436(Cal) . Both theses decisions are under the Act. In the Supreme Court decision, the question that fell for consideration was whether the balance of Rs. 5,08,637 which was carried to the balance-sheet after making a provisions for depreciation and taxation, constituted reserve within the meaning of r. 2 (1) of Sch. II of the Act. The facts in that case were that for the year ending December 31, 1945, the profits of the assessee-company, whose accounting year was the calendar year, was ascertain sum according to the profits and loss account. After making provisions for depreciation and taxation, as stated earlier, the balance of Rs. 5,08,637 was carried to the balance-sheet. This sum was not allowed in computing the profits of the assessee for purposes of income-tax. In February, 1946, the directors recommended that out of that amount a sum of Rs. 4,92,426 should be distributed as dividend and the balance of Rs. 16,211 should be carried forward to the next year's account. This recommendation was accepted amount was shortly thereafter distributed as dividend. In computing the capital of the assessee-company on January 1, 1946, under the Business Profits Tax Act, 1947, the assessee claimed that the said sum of Rs. 5,08,637 and the profits earned by it during the period January 1, 1946 to April 1, 1946 should be treated as reserves for the purposes of the said rule. The High Court held that the sum of Rs. 5,08,637 must be treated as a reserve for the purposes of the said rule, but the profits made by the assessee during the period January 1, 1946, to April 1, 1946, could not be included in the reserves. On appeal, the Supreme Court held that both the said sum of Rs. 5,08,637 as well as the profit, earned by the assessee during the relevant period did not constitute reserves within the meaning of the said rule. While discussing whether the amount in question could be called a reserve, the Supreme Court held as follows : 24ITR499(SC) :
'The term 'reserve' is not defined in the Act and we must resort to the ordinary natural meaning as understood in common parlance. The dictionary meaning of the word 'reserve' i : (a) To keep for further use or enjoyment; to store up for some time or occasion; to refrain from using or enjoying at once.
(b) to keep back or hold over to a later time or place or for further treatment.
6. To set apart for some purposes 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, retain, is defined as follow :
'1. To keep in store for further 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 further time or place
3. To preserve.'
What is the true nature and character of the disputed sum must be determined with reference to the substance of the matter and when this is borne in mind, it follows that on the April 1, 1946, which is the crucial date, the sum of Rs. 5,08,637 could not be called a 'reserve' for nobody possessed of the requisite authority had indicated on that date the manner of its disposal or destination. On the other hand, on the February 28, 1946, the directors clearly earmarked it of distribution as dividend an did not choose to make it a reserve. Nor did the company in its meeting on the April 3, 1946, decide that it was a reserve. It remained on the 1st of April as a mass of undistributed profits which were available for distribution and not earmarked as 'reserve'. On the January 1, 1946, the amount was simply brought from the profits and loss account to the next year and nobody with any authority on that date made or declared a reserve. The reserve may be a general reserve or a specific reserve, but there must be a clear indication to show whether it was a reserve either of the one or the other kind. The fact that it constituted a mass of undistributed profits on the January 1, 1946, cannot automatically make it a reserve. On the April 1, 1946, which is the commencement of the chargeable accounting period, there was merely a recommendation by the directors that the amount in question should be distributed as dividend. Far from showing that the directors had made the amount in question a reserve, it shows that they had decided to earmark if for distribution as dividend. By the resolution of the shareholders on the April 3, 1946, the amount was shortly afterwards distributed as dividend..... The directors had no power to distribute the sum as dividend. They could only recommend, as indeed they did, and it was up to 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).'
17. In this context, while discussing the provisions of ss. 131(a) and 132 of the Indian Companies Act, the court held as follows (p. 505 :
'Reference was made to sections 131(a) and 132 of the Indian Companies Act. Section 131(a) enjoins upon the directors to attach to every balance-sheet a report with respect to the state of the company's affairs and the amount, if any, which they recommend 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 No. 99 of the 1st 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 direction, be applicable for meeting contingencies, or for equalising dividends, or for any other purposes to which the profits of the company may be property 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 provision 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.'
18. The above observation of the Supreme Court, therefore, make if clear that an amount sought to be claimed as reserve must be determined with reference to the substance of the matter. It must further be clearly earmarked and appropriated as reserve and, what is more, such appropriation or earmarking must be done by an authority who has power to earmark or appropriate the sum as reserve.
19. In the Calcutta decision, the High Court has emphasised the very some aspect, viz., that before an amount is treated as reserve, the company has to indicate the manner of its disposal or destination. If the surplus is simply carried forward without the persons in requisite authority allocating it to any particular purposes as a reserve, it does not acquire the character of a reserve for the purposes of capital computation under the Business Profits Tax Act. In that case, the balance-sheet of the assessee-company for the year ending March 31, 1946, showed a sum as unappropriated balance. This sum was made up of two smaller sums, viz., (i) an amount which had been carried forward out of the balance as at the last date of the previous year, i.e., as on March 31, 1945, and (ii) an amount which was the balance of the profits for that year, 1945-46. The assessee claimed that it was entitled to have the entire sum treated as reserve for the purposes of the computation of its capital for the chargeable accounting period ended March 31, 1947, under r. 2(1) of Sch. II to the Business Profits Tax Act, 1947. The Tribunal allowed the assessee's claim with regard to the amount carried forward from the previous year 1944-45 but rejected its claim is respect of the balance of the profits for the year 1945-46. The High Court, on a reference, held that, as the company had not indicated the manner of disposal or the destination of the balance of profits of the previous year 1944-45 as well as the profits of the year 1945-46, neither amount could be considered to be a reserve for the purposes of the said rule. According to the High Court, if the surplus is simply carried forward without the person in requisite authority allocating it to any particulars purposes as a reserve, it does not acquired the character of a reserve for the purposes of capital computation under the Business Profits Tax Act.
20. These two decisions, therefore, make the position in law clear on the point, viz., that the amount has to be specifically earmarked or appropriated as reserve and that such appropriation has to be done by the requisite authority. A mere carrying forward of an amount or a surplus profit without requisite authority would not acquire the character of a reserve for the purposes of capital computation under the Act. It is in the light of this position in law that we have to examine whether the amount in question constitutes a reserve. It is also interesting to not that in the present case the claim is not only that the amount in question is a reserve but that it is a secret reserve and that the assessee is entitled to maintain such secret reserve and the same is entitled to be calculated in the capital base of the assessee for the purposes of calculation of surplus profits under the Act. It will, therefore, also be necessary to find out what exactly is meant by secret reserve and whether the assessee is entitled to maintain such secret reserves.
21. In the course of the argument, both sides referred us to some authoritative text books on book-keeping and accounts where a reference to secret reserve and to the method and manner of maintaining them has been made.
22. In Spicer and Pegler's Book-keeping and Account's, 17th Edn., at p. 68, the term 'secret reserve' has been explained as follow :
'The term 'secret reserve' is used to denote reserve which exist nut ate not disclosed on the face of the balance-sheet.
Secret reserves may arise in two ways, viz., by the deliberate action of creating them, or by unrecorded appreciation in the value of assets. It would normally be unusual to writ up assets for an unrealized appreciation in value, hence the appreciation is not as a rule shown on the face of the balance-sheet.
Secret reserves may be created deliberately b :
1. Writing down assets below their market value by excessive provisions for depreciation.
2. Writing off assets altogether, although they are still of value
3. Creating excessive provisions for bad debts
4. Charging capital expenditure to revenue.
5. Omitting goodwill from the accounts.
6. Overstating liability in the balance-sheet.
7. Treating reserves for contingencies as provisions for specific liabilities.
8. Grouping free reserves with liabilities, so as to inflate the liability on the balance-sheet.
9. Crediting exceptional or non-recurring profits direct to a contingencies reserves, and including such reserves in the liabilities on the balance-sheet.
The following objections may be made against the practice of creating and maintaining secret reserve :
1. The resulting balance-sheet will not disclose a true and fair view as the assets will be understated and/or the liability overstated.
2. The Profit and Loss Account, where affected, will not show the correct profits, and consequently the dividend declared may be less than would otherwise have been possible.
3. The practice could lend itself to the manipulation of profits, and to improper dealings in the shares of a company by person who were aware of the existence of the secret reserves.
4. If the use of secret to pay dividends is not disclosed in the published accounts members will not know that the revenue for the period was insufficient to pay the dividend. The true trading results may thus be obscured.
5. Assets, once depreciated, cannot be written up without attracting attention, whereas reserves for contingencies, being merged with creditors, can be manipulated with little risk of discovery. Hence overstatement of liabilities is open to more objection than under valuation of assets.
On the other hand the practice of creating secret reserves is often advantageous; banks and insurance companies can maintain the payment of dividends without violent fluctuations, and exceptional losses need not harm their credit, which although alarming to the uninitiated, do not shake their stability.'
23. In Pickles and Lafforty's Accountancy, 4th Edn., on page 0719, reference is made to reserve which are not disclosed in the balance-sheet and they are classified as hidden reserves, inner reserves and secret reserves. They have been described as follow :
'1. Hidden reserves, where an item of profits is (including revenue or capital reserve) described in such a manner as to indicate a liability, being included for instance in sundry creditors.
2. Inner reserves, where a provisions is made to cover exceptional and abnormal losses, and such provision is not openly disclosed, e.g. generally contingencies reserves (in the case of a bank) included in creditors, usually under the heading of 'Deposit, current and other account's.
3. Secret reserves, where the net asset position is stronger than that disclosed by the balance-sheet by reason o :
(a) Excessive depreciation of an asset (particularly goodwill), or excessive valuation of a liability, or excessive provisions.
(b) Complete elimination of an asset ; under valuation or understatement of an asset
(c) Charging capital expenditure to revenue, or crediting revenue receipt to an asset (e.g. dividends received and earned credited to the investment).
(d) Permanent appreciation in a fixed asset, or permanent diminution or extinction of liability not recorded.
(e) Showing a contingent liability as an actual liability or as a provision therefore; or an actual assets as a contingent asset.
(f) Grouping of 'free' reserves with creditors.
(g) Crediting exceptional or non-recurring profits to a contingencies reserves without proper disclosure.
(h) Allowing undistributed surplus in the hands of a subsidiary company.
An example of the creation of a secret reserves is seen where a bank provides for depreciation of investment, but does not re-credit a subsequent appreciation of investments.
From this it will be seen that secret reserves may -
(i) arise, as in (d),
(ii) be created, as in the remainder of the examples given,
(iii) be maintained, by allowing (i) to remain or by continuing the practice in (ii).'
So also in Batliboi's Advanced Accountancy, 27th Edn., at p. 724, a similar explanation is given with regard to secret or inner reserves.
24. It will thus appear from the aforesaid description of secret reserves given in the text books that there are various modes of forming secret reserves and one of the ways is to undervalue the stocks of share and securities. Since such an operation reduces the value of the assets without the fact being disclosed in the balance-sheet, they become secret and hidden and are known only to the management. It is also observed in these books that nearly all banks and financial institution have such secret and inner reserves. Whether they are excessive or not can be decided only be examination of their intention. The justification for secret reserve is that the directors sometimes experience a reluctance on the part of the shareholders to deny themselves a full distribution of profits in order to form reserves funds, and also a desire to average one year's profits with another. The equalisation of profits in this manner not only gives a business the impress of stability but helps to ensure a regular income to the shareholders. Secret reserves enable the business to meet extraordinary losses without the same being disclosed and thus prevent the public confidence being shaken.
25. It will now be advantageous to refer to the banking Regulation Act 1949, which was applicable to the assessee and which lays down the manner in which the assessee was, at the relevant time, liable to maintain accounts and publish its balance-sheet. Section 29 contains a provisions with regard to maintenance of accounts and balance-sheet. It states that the balance-sheet and profits and loss account of the banking company will be in the forms set out in the Third Schedule and that it shall be signed by the manager or the principle officer of the company, and where there are more than three directors of the company, by at least three of those directors, or where there are not more than three directors, by all the directors. The form in which the profit and loss account is to be maintained is Form 'B' of the Third Schedule and on its income side, a column is provided which enables the banking company, to state the income (less provisions made for had and doubtful debts and other usual or necessary provisions). This income is to be included in the item which is described as net profits on sale of investment, gold and silver, land, premises, and other assets (not credited to reserves or any particular fund or account). It is clear from this provisions of s. 29 read with Form 'B' that the Act envisages that there will be profits on sale of investments of the company which may not be credited to reserves or any particular fund or account as shown in the balance-sheet. Further, the provisions that the balance-sheet and the profit and loss account will have to be signed, whenever there is a board of directors, by the directors show that the statement made in the balance-sheet and the profit and loss account when signed will be deemed to have been perused by them and their appropriation of the amounts to the different accounts will be deemed to have been done under their authority.
26. Section 30 refers to the audit of the account, section 31 refers to the submission of returns by the assessee to the Reserve Bank, and s. 32 contains a provisions with regard to furnishing of balance-sheets and accounts to the Registrar under the Companies Act. Section 34 then lays down that no banking company shall be compelled by any authority to produce or give any inspection of its books of account or any documents or furnish or disclose any statement or information in any proceeding before it when the banking company claims that such information would disclose information relating to any reserves not shown as such in its published balance-sheet or any particulars not shown therein in respect of provisions made or bad and doubtful debts and other usual or necessary provisions. The provisions of this section themselves imply that there may be reserves other then those shown in the published balance-sheet. Theses provisions, therefore, impliedly recognise the practice of maintaining secret, inner or hidden reserves.
27. Section 35 provides for an inspection of the banking company's accounts by the Reserves bank. Section 35A gives power to the Reserves Bank to give direction to the banking company in the public interest or in the interest of the banking police or to prevent the affairs of the company being conducted in a manner detrimental to the interests of the depositors or prejudicial to the interest of the banking company or to secure its proper management in general. The provisions of ss. 35 and 35A make it clear that the Reserves Bank has an overriding power to supervise and control the affairs of the banking company which includes the power of inspection of all books, accounts and other documents of company. This will undoubtedly include the power to inspect books of account which show the hidden or secret reserves.
28. It will be interesting in this connection to make a reference to a decision of the Supreme Court in All India Bank Employees' Association v. National Industrial Tribunal (Bank Disputes), Bombay : (1961)IILLJ385SC . In this case, the constitutional validity of the said s. 34A of the Banking Companies Act. 1949, was challenged on the ground that it was ultra vires arts. 19(1)(c) and 14 of the Constitution. While upholding the validity of the said section, the Supreme Court had to discuss the practice of maintaining secret reserves and this is what the court had to say with of maintaining secret reserves and this is what the court had to say with reference to the said practice, at p. 433 of he report :
'From what we have stated earlier as the genesis of the legislation now impugned, it would be apparent that Government had to effect a reconciliation between to conflicting interest : one was the need to preserve and maintain the delicate fabric of the credit structure of the country by strengthening the real as well as the apparent credit-worthiness of banks operating in the country. It was really this principle which is vital to the economic life of the community that has been responsible for the changes that have been made from 1927 onwards as regards the form of balance-sheets and of the profits & loss accounts of banking companies as distinguished from other trading and industrial organisations. There was urgent need to protect from disclosure certain of the items of appropriation by banks in order to preserve them as credit institutions. On the other, hand, there was the need-an equally urgent need-for enabling the worked in these institution not to be denied a proper wages and other emoluments and proper conditions of service. The question was how far information which in the interests of national economy the banks were entitled to withhold from their shareholder and the general public, was to be made available for determining the capacity of the banks to pay their employees. It was in these circumstances that the impugned legislation was enacted which while preserving industries adjudication in respect of disputes between the banks and their employees, entrusted the duty of determining the surplus reserve which could be taken into account as part of the assets for determining capacity to pay, to the Reserve Bank. Thus, understood there does not appear to be anything unreasonable in the solution which the impugned legislation has effected.'
29. Theses observations will further show that even Supreme Court had accepted the practice of the banking companies maintaining secret reserves which are not disclosed in the balance-sheet but which are necessary in the interests of national economy, preservation and maintaining the delicate fabric of the credit of the country by strengthening the real as well as the apparent credit worthiness of banks operating in the country. The provisions of the Banking Regulation Act, therefore, in terms permit the maintenance of such secret reserves in the interests of healthy banking practices. The said provisions also further show that the balance-sheets and profits and loss accounts are to be signed by the directors and, therefore, the allocation shown in the balance-sheet and the profit and loss account should always be deemed to have been done at the instance of the directors. The balance-sheet and the profit and loss accounts are only summary of the books of account of the company. It is into disputed that the secret reserves though not shown in the balance-sheet and profit and loss accounts find their place in the books of account and are reflected therein. Hence, on the reading of the provisions of the Banking Regulation Act, it will have to be held that secret reserves are maintained and allocations of the profits to such reserves is done at the instance of the board of directors of the company.
30. This position in law also emerge from a reading of the Companies Act, 1956.
31. Section 211 of the Companies Act, 1956, provides for the form and contents of the balance-sheet and profit and loss account of a company registered under the Act. The assessee like any other banking company is also registered under the said Act.
Sub-section (2) of the said section provides that every profits and loss account of a company shall give a true and fair view of the profits or loss of the company, and comply with the requirements of Pt. II of Sch. VI, so far as they are applicable thereto.
Sub-section (5) thereof then states that the balance-sheet and the profit and loss account of a company shall not be treated as not disclosing a true and fair view of the state of affairs of the company, merely by reason of the fact that they do not disclose, in the case of a banking company, any mater which is not required to be disclosed by the Banking Companies Act, 1949. As pointed out earlier, by virtue of s. 34A of the Banking Regulation Act, the banking company is entitled not to disclose among other things, its secret reserves. Hence, the balance-sheet as published by any banking company will have to be taken as disclosing or reflecting the true and fair affairs of the company and cannot be questioned for want of express information with regard to the secret reserves. This will also mean that if the company claims that it has maintained secret reserve, that claim will have to be accepted in spit of the fact that they are not reflected in the published balance-sheet or accounts. It will also have further to be accepted that such reserves are kept at the instance of the board of directors of the company. That is so because even by virtue of s. 215 of the Companies Act, 1956, read with s. 29(2) of the Banking Companies Act, 1949, the balance-sheets have to be signed by the board of directors before they are submitted to the auditors for their report thereon. Sub-s. (3) of s. 217 of the Companies Act further required that the board is bound to give the fullest information and explanations in its report made to the general meeting on every reservation, qualification or adverse remarks contained in the auditor's report. The another has further to make his report after inspecting each and every document, and under the Companies Act he has a right of access at all times to the books and accounts and vouchers of the company as per the provisions of s. 227 of the Companies Act. The auditors' report made after inspecting the account of the company has to state that he has obtained all the information and explanations which were necessary for the purposes of his audit and that, in his opinion, proper books of accounts have be maintained and further that the company's balance-sheet and profit and loss account are all in agreement with the books of account. As has been stated earlier, although the secret reserves do not find a place in the published balance-sheet and profits and loss account, and the balance-sheet and the profit and loss account which he prepares are only a summary of the said books of account, and in view of the further fact that he had to certify that this summary is in accordance with and reflects truly and faithfully the books of account of the company, it will have to be held that the balance-sheet and the profit and loss account as published is a true genuine summary of the financial position of the company and that it will have to be taken as such, and it will not be permissible to go behind it.
32. It is true that the final authority for the conduct of the affairs of a company lies with the members or shareholders of the company. However, it does not mean that they have unrestricted rights in all matters relating to the affairs of the company. Their authority can be restricted or circumscribed by an express provision made in that beheld under the memorandum and articles of association. There is no common law right to inspect the company's accounting records or to have a say in the allocation of funds to any particular account. As has been stated in Paennington's Company Law, 4th Edn., p. 617, the members of a company have no statutory or common law right to inspect the company's accounting records, and they enjoy such right only if it is given by the articles of association, which is rare. There is no dispute that the articles of association of the assessee do not given any such right to its shareholders. On the board of directors of the company to determine from time to time whether and to what extent and what at times and places and under what conditions or regulations, the accounts and books of the company. Or any of them, shall be open for inspection by the members who are not direction. Sub-clause (2) of the said regulation further lays down that no members (not being a director) shall have any right of inspecting any account or books or documents of the company except as conferred by law or authorised by the board or by the company in general meetings. Therefore, it is correct to say that the authority to allocate funds to different accounts does not necessarily vest in the shareholders of the company unless there is an express provision for the same. As far as the present case is concerned, sub-cl. (19) of art. 109 of the articles of association of the assessee-company gives a power to the directors of the company which reads as follow :
'Before recommending any dividend, to set aside out to the profits of the company, such sums as they think proper as a reserve fund to meet contingencies, or for equalising dividends, or for special dividends, or for repairing, improving, and maintaining any of the property of the company and for such other purpose of the directors shall in their absolute discretion think conductive to the interests of the company; and to invest the several sums so set aside upon such investments (Other than shares of the company) as they may think fit, and from time to time to deal with and very such investment and dispose of all any part thereof for the benefit of the company and to divide the reserve fund into such special funds as they think fir with power to employ the assets constituting the reserve fund in the business of the company, and that without being bound to keep the same separate from the other assets.'
33. In the present case, therefore, reading the provisions of the said art 109(19) of the articles of association together with the provisions of s. 29 of the Banking Regulation Act, and s. 215 of the Companies Act relating to the signing of the balance-sheet and the profit and loss account, the position which emerges is that it is the board of directors who have authority to allocate funds to the reserves account. It is not disputed that the balance-sheet and the profit and loss account of the assessee has been singed by the board of directors. Therefore, the positions which is reflected in the balances-sheet and the profit and loss account, which reflection includes the hidden or secret reserves, will be deemed to have been at the instance of the requisite authority.
34. The question whether these reserves are ascertainable or not need not cloud the fact that the secret reserves do exist and that they do so at the instance of the requisite authority. In fact, the existence of the secret as well as the AAC have proceeded on the basis that a definite amount of Rs. 76,58,687 is maintained by the assessee-company as secret reserve. Even otherwise, as has been observed in Johnston and Jager's Company Accounting 2nd Edn, at p. 396, significant information can be derived from an intelligent reading of the accounts as they stand, and among the information which may be derived by such intelligent reading, is one relating reading, is one relating to the existence or otherwise of secret reserves. This is apparent if the book value of the assets is shown far below the current market value.
35. Coming to the balance-sheet in question, item 4 in the balance-sheet is an entry under the head 'Investment at below market value'. The wording of the heading of the said item is itself eloquent and an intelligent reader can at once gather from the said entry that the said investment have been valued at below the market value for the obvious purpose of creating secret reserves. As has been pointed out earlier, in the books of account the mode by which the said figure of Rs. 76,58,687 has been shown to have been arrived at is by working out the difference between the market value of the securities and shares which is shown as Rs. 23,00,71,555.37 and the market value of the investments which is shown as Rs. 22,24,12,868.18 (which is the figure which is shown as the total value of the items mentioned in the said entry No. 4). The figure of Rs. 76,58,687.19 is shown in the books of account as standing to the credit of the account which is called the premium and discount account. This figure, as stated earlier, reflects the balances after the sale of shares and securities. It is because the assessee-company after the sale of shares and securities. It is because the assessee-company has stated the amount standing to the credit of the said account, that the company is impelled to show the value of its total investment in securities and shares less by the said amount. That is the purposes and the role which this amount, which is otherwise called secret reserves, serves in the balance of the accounts of the company as reflected in the published balance-sheet and the profits and loss accounts.
Thus, it is more than clear, firstly, that the amount is appropriated for the said reserve account by a deliberate action, and, secondly, it is so done by the power of the board of directors which is the requisite authority down buy the Supreme Court in CIT v. Century Spinning and . : 24ITR499(Bom) , for an appropriation of funds to the reserves accounts are, therefore, fully satisfied in the present case. The said amount will, therefore, be entitled to be called 'reserve' notwithstanding that it is not in so many figures reflected in the profit and loss account or the published balance-sheet. Hence, it will have to be counted in the capital of the company for the purpose of r. 1 of Sch. II of the S.P.T. Act.
36. In the result, our answer to the first question is in the affirmative and in favour of the assessee. In view of the fact that question Nos. 2 and 3 do not survive, the same are not answered. The revenue to pay the costs of the assessee.