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Commissioner of Income-tax, Delhi (Central) Vs. Orissa Cement Ltd. - Court Judgment

LegalCrystal Citation
SubjectDirect Taxation
CourtDelhi High Court
Decided On
Case NumberIncome-tax Reference No. 4 of 1972
Judge
Reported in[1980]124ITR251(Delhi); [1981]6TAXMAN387(Delhi)
ActsSuper Profits Tax Act, 1963 - Schedule - Rule 1; Income Tax Act, 1961 - Sections 28, 29, 34 and 256(1); Wealth Tax Act, 1957 - Sections 2
AppellantCommissioner of Income-tax, Delhi (Central)
RespondentOrissa Cement Ltd.
Excerpt:
direct taxation - assessment - rule 1 of schedule to super profits tax act, 1963, sections 28, 29, 34 and 256 (1) of income tax act, 1961 and sections 2 of wealth tax act, 1957 - whether gratuity reserve of rs. 335000 created by assessed-company form part of capital as per second schedule to act of 1963 - setting apart of gratuity amount not result of ascertainment of present value of future liability - as such amount set apart by assessed to meet liability for gratuity treated as reserve - held, rs. 3350000 represented reserve and treated as part of capital for purpose of act of 1963. - - the nature of the amount, which was nothing more than the undistributed profits of the company, remained unaltered by the recommendation made by the directors who had not taken any action, before.....s. ranganathan, j. 1. the question as to how far certain funds can be held to constitute 'reserves' has assumed great importance in the context of certain legislations by which the revenue attempted to syphon off, by way of tax, a portion of the profits earned by a business over and above a particular standard of return on the funds invested in the business. 2. to start with, there was the excess profits tax act, 1940, which is not relevant for our present purposes. then there was the business profits tax act (act 21 of 1947). by this act, the taxable profits from a business during a chargeable accounting period were computed and to the extent they exceeded an amount calculated at 6% on the capital employed in the business on the first day of the said period, they were subjected to a tax......
Judgment:

S. Ranganathan, J.

1. The question as to how far certain funds can be held to constitute 'reserves' has assumed great importance in the context of certain legislations by which the revenue attempted to syphon off, by way of tax, a portion of the profits earned by a business over and above a particular standard of return on the funds invested in the business.

2. To start with, there was the Excess Profits Tax Act, 1940, which is not relevant for our present purposes. Then there was the Business Profits Tax Act (Act 21 of 1947). By this Act, the taxable profits from a business during a chargeable accounting period were computed and to the extent they exceeded an amount calculated at 6% on the capital employed in the business on the first day of the said period, they were subjected to a tax. For the purposes of the Act, the capital in the case of a company was defined to represent the sum of the amounts of 'its paid up share capital and of its reserves 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'.

3. The Super Profits Tax Act, 1963, also laid down a similar rule. Here again, the super profits represented the excess of its chargeable profits of a previous year over the standard deduction, which represented an amount equal to 6% of the capital of the company as computed in accordance with the provisions of the Second Schedule. The Second Schedule contained rules for computing the capital of a company for the purposes of the Act. Rule 1 of the Schedule, in effect, so far as is material for our purposes, provided that 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 reserves except those which are allowed as deductions in computing the profits of the company for the purposes of the Indian I.T. Act, 1922, or the I.T. Act, 1961.

4. It will be seen that both the above enactments were identical in their terms. They did not contain any definition of the expression 'reserves'.

5. The Super Profits Tax Act gave way to the Companies (Profits) Surtax Act 1964. So far as we are concerned it may be taken that there is no substantial difference between the two Acts in their main objective. The charge of tax under this Act is in respect of so much of the chargeable profits of the previous year as exceed the statutory deduction. Statutory deduction is defined as an amount equal to 10% of the capital of the company as computed in accordance with the provisions of the Second Schedule. Rule 1 of the Second Schedule, in so far as is relevant for our present purposes, runs as follows :

6. Subject to the other provisions contained in this Schedule, the capital of a company shall be the aggregate of the amounts, as on the first day of the previous year relevant to the assessment year, of -

(i) its paid-up share capital; (ii) its reserves, if any, created under the proviso (b) to clause (vib) of sub-section (2) of section 10 of the Indian Income-tax Act, 1922 (XI of 1922), or under sub-section (3) of section 34 of the Income-tax Act, 1961 (XLIII of 1961);

(iii) its other reserves as reduced by the amounts credited to such reserves as have been allowed as a deduction in computing the income of the company for the purposes of the Indian Income-tax Act, 1922 (XI of 1922), or the Income-tax Act, 1961 (XLIII of 1961);...... Explanationn. - For the removal of doubts it is hereby declared that any amount standing to the credit of any account in the books of a company as on the first day of the previous year relevant to the assessment year which is of the nature of item (5) or item (6) or item (7) under the heading 'RESERVES AND SURPLUS' or of any item under the heading 'CURRENT LIABILITIES AND PROVISIONS' in the column relating to 'Liabilities' in the 'FORM OF BALANCE-SHEET' given in Part I of Schedule VI to the Companies Act, 1956 (1 of 1956), shall not be regarded as a reserve for the purposes of computation of the capital of a company under the provisions of this Schedule.

7. It will be seen that the above Act does not contain any definition of 'reserves' but it clarifies, with reference to the balance-sheet prescribed for a company under the Companies Act, that any item which is displayed in the balance-sheet under the heading 'Current liabilities and provisions' would not constitute a 'reserve' and also that any item displayed against items Nos. (5), (6) and (7) in the balance-sheet under the heading 'Reserves and Surplus' shall also not be treated as a reserve. It may be clarified here that on the liabilities side of the balance-sheet, there first appear the figures of the share capital of the company followed by various items under the head 'Reserves and surplus'. Items (5), (6) and (7) are as follows :

'(5) Surplus, i.e., balance in profit and loss account after providing for proposed allocations, namely :-

Dividend, Bonus or Reserves. (6) Proposed additions to Reserves.

(7) Sinking Funds.'

8. Then follow the headings 'Secured loans' and 'Unsecured loans'. Then occurs the heading 'Current liabilities and provisions'. Under the head 'Current liabilities' are to be shown the liabilities of the company towards 'acceptances, sundry creditors, subsidiary companies, advance payments and unexpired discounts, unclaimed dividends', other liabilities, if any, and liability by way of interest accrued but not due on loans. Under the sub-head 'Provisions' mention is made of provision for taxation, for proposed dividends, for contingencies, for provident funds scheme, for insurance, pension and similar staff benefit schemes and other provisions.It is further clarified that a foot-note to the balance-sheet may be added to show separately claims against the company not acknowledged as debts, uncalled liability on shares partly paid, arrears of fixed cumulative dividends, estimated amount of contracts remaining to be executed on capital account and not provided for and other money for which the company is contingently liable. Reference may also be made in this context to r. 7 in Pt. III of this Schedule to the Companies Act which sets out the interpretation of the various expressions used in the balance-sheet. This rule runs as follows :

'7. (1) For the purposes of Parts I and II of this Schedule, unless the context otherwise requires, -

(a) the expression 'provision' shall, subject to sub-clause (2) of this clause, mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy;

(b) the expression 'reserve' shall not, subject as aforesaid, include any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets or retained by way of providing for any known liability;

(c) the expression 'capital reserve' shall not include any amount regarded as free for distribution through the profit and loss account; and the expression 'revenue reserve' shall mean any reserve other than a capital reserve;

and in this sub-clause the expression 'liability' shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities.'

9. Sub-rule (2) of the above rule clarifies that where an amount of provision is made in excess of the amount which in the opinion of the directors is reasonably necessary for the purpose, the excess shall be treated for the purposes of the Schedule as a 'reserve' and not a 'provision'.

10. A large number of judicial decisions have been rendered on the question whether certain types of allocations made by companies constitute 'reserves' for the purposes of these enactments. Before discussing these decisions, it would be appropriate to mention that, in the present case, we are concerned with the question whether, under the provisions of the Super Profits Tax Act, 1963, an amount standing to the credit of 'the gratuity reserves' of the Orissa Cement Ltd., New Delhi, as on the first day of January, 1962, relevant for the previous year ended on December 31, 1962, would constitute a 'reserve' includible in the capital base of the company. The ITO took the view that this amount represented a provision for a known contingent liability and was, thereforee, not a reserve. On appeal, the AAC, after pointing out that the reserve for gratuity was not allowed by way of deduction for computing the profits under the I.T. Act and that the amount had been shown by the assessed in the balance-sheet under the head 'Reserves and Surplus', was inclined to agree that the gratuity reserve was not a provision but a reserve as contemplated in r. 1 of the Second Schedule to the Super Profits Tax Act, 1963. This view of the AAC was upheld by the Tribunal. The Tribunal referred to the dictionary meaning of the word 'reserve' and observed that in the present case 'the assessed has kept back such portion of the profits and created a reserve in the shape of gratuity reserve, in order to meet its obligation to pay gratuity to its employees'. As such it was of opinion that the above amount of Rs. 3,35,000 should be duly taken note of while computing the capital of the assessed for the purposes of the Act. It is the correctness of this conclusion of the Tribunal that has been challenged in this reference made under s. 19 of the Super Profits Tax Act, 1963, read with s. 256(1) of the I.T. Act, 1961. The question referred for our opinion is :

'Whether, on the facts and in the circumstances of the case, the Income-tax Appellate was legally correct in holding that the gratuity reserve of Rs. 3,35,000 created by the assessed-company in earlier years should form part of its capital in accordance with the provisions of the Second Schedule to the Super Profits Tax Act, 1963 ?'

11. The interpretation of the expression 'reserve' came up for the consideration of the Supreme Court in three cases under the Business Profits Tax Act. The first of these cases was that of CIT v. Century Spinning and . : [1953]24ITR499(SC) . In that case, the court was concerned with a certain sum of money which remained after making provisions for depreciation and taxation against the profits of the year. At the relevant date the directors had made a recommendation that a substantial portion of this amount was to be distributed by way of dividends (indeed this was done a few days later) and that the balance should be carried forward to the next year's account. The Supreme Court held that as on the relevant date i.e., the first day of January, 1946, no competent authority had decided as to how the balance of the profits should be dealt with. The nature of the amount, which was nothing more than the undistributed profits of the company, remained unaltered by the recommendation made by the directors who had not taken any action, before they recommended a dividend, to set aside any portion of the amount as reserve or reserves.

12. The above aspect of the problem has no relevance to the present case. What is material for our present purposes is, however, that in the absence of a definition in the statute, the Supreme Court approved of the resort to the ordinary natural meaning of the word as understood in common parlance. As to this, their Lordships did not differ from the interpretation placed on the expression by Chagla C. J.who observed (See CIT v. Century Spg. and Mfg. Co. Ltd., [1951] 20 ITR 265, 265 (Bom)) :

'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 dividends to the shareholders but kept by the directors for any purpose to which it may be put in future.'

and again at page 266 :

'It is not sufficient for the company to earn profits. Having earned profits it must then by some conscious act determine what part of these profits should be kept back. It is only when part of these profits is kept back that it constitutes reserves. We are told that these profits were used in business and, thereforee, they constitute reserves. But, what makes a part of the profits reserves is not the fact that they are used in the business but that they are consciously kept back and not distributed amongst the shareholders as dividends.'

13. In that case, the High Court had held that, since the directors had not actually distributed the amount in question as dividends but kept it back, it constituted a reserve. The Supreme Court only pointed out that this application of mind and holding back should be by a competent authority. It was pointed out that, under the Companies Act, the directors could not distribute but could only recommend the distribution of the whole or part of the amount as dividend, and this they had in fact done; and as at the relevant date, the persons having requisite authority (viz., the directors) had not, before recommending the dividend, taken any action to set aside any portion of the sum as reserve or reserves, as they should have done.

14. In its subsequent discussions under the Business Profits Tax Act, viz., First National City Bank v. CIT : [1961]42ITR17(SC) and CIT v. Standard Vacuum Oil Co. : [1966]59ITR685(SC) , the Supreme Court had to consider whether in the case of American companies, amounts standing in the accounts under heads bearing certain specific nomenclatures could be treated as reserves for the purposes of the Act. After analysing the provisions of the American statutes concerned, the court came to the conclusion that the amount in question represented a part of the reserves of the company. These decisions, thereforee, are not of much guidance here.

15. At this stage, we may point out that even the principle laid down in the Century's case : [1953]24ITR499(SC) is also of limited help here as the problem before us is somewhat different. In the present case, as also in the other cases to which reference will be made presently, there is no doubt that the concerned persons in authority in the company had applied their minds and decided that the amount should be utilised towards payment of the gratuity to the employees of the company. To that extent there is no dispute. The objection raised, however, is that the earmarking is in the nature of a 'provision' and not a 'reserve'. It is said that in company law as well as in accountancy there is a clear and well-recognised distinction between these two expressions and that it is only a reserve, properly so called, and not a provision that can enter into the computation of the capital base.

16. As has already been mentioned, there have been innumerable cases dealing with this question in regard to various types of allocations and ear markings made by companies out of their profits. It would neither be possible nor necessary nor useful to make a reference to all these cases here. It would be sufficient to refer only to those decisions which specifically deal with amounts set apart to a gratuity account or a gratuity reserve. But, before doing this, it is necessary to refer to certain decisions of the Supreme Court. One of these is of general guidance while the others explain the nature of the liability of a company in respect of gratuity payable to its employees.

17. In Kesoram Industries and Cotton Mills Ltd. v. CIT : [1966]59ITR767(SC) , the Supreme Court had to consider the question whether the liability of a company for payment of income-tax for a particular accounting year could be treated as a 'debt owed' by the company as on the last date of the accounting year for purposes of the W.T. Act, 1957. The Supreme Court answered the question in the affirmative. It was pointed out that the liability to pay income-tax arose as on the last day of the accounting period and that, though the quantum thereof would normally be ascertained only on assessment, there can be no doubt that there was in existence a liability in praesenti as on the last date of the accounting year and this was sufficient to constitute a debt owed by the company on that date.

18. On the principle of the above decision, the question arose whether the amounts payable by a company by way of gratuity to its various employees could be claimed as deductions for purposes of the W.T. Act. The Supreme Court had deal with this question in Standard Mills Co. Ltd. v. CWT : [1967]63ITR470(SC) . In this case, certain awards had been made by the industrial court as well as the Labour Appellate Tribunal before the relevant valuation date. Under the awards, gratuity was payable to an employee at certain specified but varying rates, (i) on his death while in service, (ii) on his voluntary retirement or resignation after 15 years' continuous service, and (iii) on termination of his service after certain specified periods, but gratuity was not to be paid to an employee who was dismissed for dishonesty or misconduct. It was contended on behalf of the assessed that an estimated amount in respect of such liability could be deducted. For this contention, reliance was placed on the decision of the House of Lords in Southern Railway of Peru Ltd., v. Owen [1957] 32 ITR 737, to the effect that 'in computing the taxable profits for a particular year, a trader who is under an obligation to pay his employees for their services in that year by an immediate payment and also a future payment in some subsequent year may properly deduct not only the immediate payment but also the present value of the future payment provided such present value can be satisfactorily determined or fairly estimated'. In other words, it had been held by House of Lords that the present value of a future liability could also be deducted in the computation of taxable profits for income-tax purposes. On the same analogy, it was contended in the case before the Supreme Court that the present value of the future liability for payment of gratuity was a permissible deduction under the W.T. Act. This contention was repelled. Shah J., speaking for the court, observed (p. 474) :

'Apart from the concession made by counsel for the company, there is little doubt on the plain terms of the awards that the liability to pay gratuity to the employees of the appellant-company on determination of employment is a mere contingent liability which arises only when the employment of the employee is determined by death, incapacity, retirement or resignation.'

19. After considering the terms of the awards, the learned judge observed (p. 474) :

'The right to obtain gratuity under the awards arises only when there is determination of employment and not before. The liability does not exist in praesenti : it is contingent upon the determination of employment.'

20. Referring to Kesoram's case : [1966]59ITR767(SC) , it was pointed out that the decisions approved in that decision 'also accepted the legal position that a liability depending upon a contingency is not a debt in praesenti or in futuro till the contingency happened'. That case only decided that, if there was a present liability, the fact that the amount is to be ascertained does not make it any the less a debt since the liability is certain and what remains is only the quantification of the amount. The decision of the House of Lords was distinguished on the ground that it was a case concerned to determine the deductibility of the present value of a liability which may arise in future in the computation of taxable profits for the relevant year under the I.T. Act but that the same considerations could not apply to a case under the W.T. Act where the liability to pay wealth-tax is charged upon the net wealth of an assessed. The view to the contrary that contingent liabilities could also be taken into account while computing the net wealth of assessed, taken in New Rajpur Mills' case [1965] 56 ITR 544 , was disapproved.

21. The same question arose for consideration in a different context before the Supreme Court in Metal Box Company of India Ltd., v. Their Workmen : (1969)ILLJ785SC ; 39 Comp Case 410. In this case, the court was concerned with the deductibility of the liability towards gratuity while computing the available surplus for purposes of bonus under the Payment of Bonus Ordinance, 1955. The company, while computing the available surplus for purposes of bonus, had reduced the gross profits, inter alia, by a provision for gratuity to the extent of Rs. 18,38,605. It was held by the Industrial Tribunal that the company could legitimately reduce its profits only to the extent of Rs. 12.38 lakhs and that the balance of Rs. 6 lakhs was liable to be added back. Before proceeding further it is necessary to clarify that the sum of Rs. 18.38 lakhs represented the provision made by the company towards its estimated liability under two gratuity schemes framed by the company. In 1960, the company had introduced a gratuity scheme for its employees other than its officers. Under that scheme gratuity was payable on the termination of an employee's service due to retirement, death or termination, the amount of gratuity being dependent on his wages and the number of years of service put in by him. The company had worked out on an actual valuation its estimated liability and made provision of such liability not all at once but spread over a number of years. Thus, in 1959-60, 1960-61 and 1961-62, the company had allocated towards the liability Rs. 5 lakhs, Rs. 10 lakhs and Rs. 5 lakhs respectively from out of the profits and debiting the amounts in the profit and loss account. Similar provision was made in subsequent years and in all Rs. 40 lakhs had been provided in the aforesaid manner against the said liability. The practice followed by the company was that every year the company worked out the additional liability incurred by it on the employees putting in every additional year of service. Whenever an employee retired, the amount of gratuity payable to him was debited against the amount provided for as aforesaid and not to the profit and loss account as an outgoing or expenditure. In the year 1964-65, the company provided Rs. 7 lakhs under this scheme towards its additional liability on this account for this year. There was another gratuity scheme introduced by the company in 1964-65 for its officers. According to the company, the estimated liability under this scheme worked out to Rs. 20 lakhs but instead of providing for the whole of it, it provided only Rs. 11.38 lakhs. The sum of Rs. 7 lakhs and Rs. 11.38 lakhs thus set apart for the two schemes were debited in the profit and loss account and this went to reduce of gross profits. The employees' union objected contending that only a sum of Rs. 2.18 lakhs that had been actually paid during the year as gratuity to those who retired could be deducted and not the balance. What the Tribunal did, however, was that instead of squarely facing this controversy, it held that as the company had debited only Rs. 5 lakhs in 1959-60 and 1961-62 it would allow only Rs. 5 lakhs for each of these schemes. In addition to this sum of Rs. 10 lakhs it allowed the actual payment of Rs. 2.18 lakhs and added back the sum of Rs. 6 lakhs to the figures shown by the company. In this state of facts, two questions arose for the consideration of the Supreme Court (p. 62 of 73 ITR) :

(1) Whether it was legitimate in such a scheme of gratuity to estimate the liability on an actuarial valuation and deduct such estimated liability in the P & L Account while working out its net profits; and

(2) If it was, whether such appropriation amounted to a reserve or a provision for, if it was a reserve, the amount would have to be added back but the company would be entitled to deduct interest at 6% thereon before arriving at the available surplus.

22. On the first question, the Supreme Court referred to Kesoram : [1966]59ITR767(SC) and Standard Mills : [1967]63ITR470(SC) and observed (p. 64 of 73 ITR).

'These observations (i.e., those made in Standard Mills) show that the court was of the view that though such a liability is a contingent liability and thereforee not a 'debt' under section 2(m) of the Wealth-tax Act, it would be deductible under the Income-tax Act while computing the taxable profits. In the instant case, the question is not whether such estimated liability arising under the gratuity schemes amounts to a debt or not. The question that concerns us is whether, while working out the net profits, a trader can provide from his gross receipts his liability to pay a certain sum for every additional year of service which he receives from his employees. This, in our view, he can do, if such liability is properly ascertainable and it is possible to arrive at a proper discounted present value. Even if the liability is a contingent liability, provided its discounted present value is ascertainable, it can be taken into account. Contingent liabilities discounted and valued as necessary can be taken into account as trading expenses if they are sufficiently certain to be capable of valuation and if profits cannot be properly estimated without taking them into account. Contingent tights, if capable of valuation, can similarly be taken into account as trading receipts where it is necessary to do so in order to ascertain the true profits.'

23. The court referred with approval to the decision of the House of Lords in Southern Railway of Peru Ltd., v. Owen [1957] 32 ITR 73. The court also referred to the forms of balance-sheet and profit and loss account prescribed in Sch. VI of the Companies Act as showing that there is no rule against providing for any such contingent liability but, on the contrary, indicating that such a provision was permissible. The court, thereforee, concluded that an estimated liability under gratuity schemes such as the one before it, even though it amounted only to a contingent liability and was not a debt under the W.T. Act, if properly ascertainable and its present value fairly discounted, was deductible from the gross receipts while preparing the P & L Account. This was recognised in trading circles and there was no rule or direction in the Bonus Act which prohibited such a practice.

24. The second question which the court had to consider was whether the amount so set apart was a provision or a reserve. The court observed (p. 67 of 73 ITR) :

'The distinction between a provision and a reserve is in commercial accountancy fairly well known. Provisions made against anticipated losses and contingencies are charges against profits, and, thereforee, to be taken into account against gross receipts in the P & L account and the balance-sheet. On the other hand, reserves are appropriations of profits, the assets by which they are represented being retained to form part of the capital employed in the business. Provisions are usually shown in the balance-sheet by way of deductions from the assets in respect of which they are made whereas general reserves and reserve funds are shown as part of the proprietor's interest (see Spicer and Pegler's Book keeping and Accounts, 15th edition, page 42). An amount set aside out of profits and other surpluses, not designed to meet a liability, contingency, commitment or diminution in value of assets known to exist at the date of the balance-sheet is a reserve but an amount set aside out of profits and other surpluses to provide for any known liability of which the amount cannot be determined with substantial accuracy is a provision (See William Pickles Accountancy, second edition, p. 192; Part III, clause 7, Schedule VI, to the Companies Act, 1956, which defines provision and reserve).'

25. Pointing out that the company's case that the estimated liability under the gratuity schemes in respect of the accounting year was ascertainable with fair accuracy under the actuarial valuation was not disputed before the Tribunal, the court held that whole sum was deductible while arriving at the net profits in the P & L account.

26. In Bombay Dyeing and ., v. CWT : [1974]93ITR603(SC) an attempt was made to suggest that there was a conflict between the decision of the Supreme Court in Metal Box : (1969)ILLJ785SC and Standard Mills : [1967]63ITR470(SC) which required reconciliation.

27. In this case, the question that arose was whether the liability of the company in respect of gratuity in terms of industrial court awards for the benefit of its employees in respect of their period of service up to the valuation date was not deductible for the purposes of the W.T. Act. The Supreme Court held, following the earlier decision in Standard Mills : [1967]63ITR470(SC) , that the amount was not deductible. It was pointed out that the decision in the Metal Box : (1969)ILLJ785SC had been rendered under the Bonus Act and that it had considered the decision in Standard Mills and distinguished the same. It was held that there was no conflict between the two decisions.

28. At this stage, it is necessary to refer, in addition to the above decisions, to the decision of this court in the case of Delhi Flour Mills : [1974]95ITR151(Delhi) . In this case, following certain disputes between the assessed-company and its employees, a settlement was reached on February 14, 1956. Under the settlement, the employees, on completing ten years of service or more, were to be paid, on leaving work voluntarily, gratuity at 15 days' basic pay for every year of service but not exceeding, in any case, ten months' basic salary. In case of the death of an employee, the condition of ten years of service was not to apply. Pursuant to this agreement, the assessed, which maintained its accounts on the mercantile system, transferred the sums of Rs. 55,712 and Rs. 12,001 to the employees' gratuity fund respectively for the accounting periods ending on October 31, 1956, and October 30, 1957, and in its balance-sheets showed these amounts under the head 'Current Liabilities and Provisions'. The assessed also credited to the account of each one of its employees, the amount of gratuity payable under the agreement. The ITO allowed deduction of Rs. 3,078 and Rs. 425, being the amounts actually disbursed as gratuity during those years and disallowed the balance. The High Court, however, held on a reference, that the entire provision made by the assessed for payment of gratuity was in the nature of a revenue expenditure and was allowable under the I.T. Act. It was held that the gratuity payable to an employee represented a part of the emoluments payable to him for rendering service during each year. The right to receive gratuity accrued to the employee as soon as he completed an year of service, and, as a corollary, the liability to pay the gratuity to the employee arose to the assessed at the end of each year. The amount of liability was also ascertainable and there was no question in this case of the discounted present value of the liability not being ascertainable. No doubt the actual payment of the gratuity was deferred to a later date on the happening of a certain event, viz., death or voluntary retirement of the employee, but these were not uncertain events. For the reason that gratuity might not be payable to an employee in some stray circumstances, it could not be said that the liability of the assessed for payment of gratuity to its employees under the agreement did not accrue during the relevant years. It was held that the possible of a gratuity not being paid at all to the employees in the event of dismissal or retrenchment was too remote to be taken into account. Distinguishing the decision of the Madras High Court in CIT v. Indian Metal and Metallurgical Corporation : [1964]51ITR240(Mad) , the court pointed out that in the case before them the gratuity amounts had been irrevocably transferred not to a reserve fund but to a gratuity fund as such and also that the amount of gratuity payable to each of the employees had been credited to his individual account in the books of the company.

29. It may perhaps be convenient at this stage to summarise the effect of the above decisions. The liability of an employer to pay gratuity to his employees subject to certain conditions on the occasion of death, retirement or resignation which is to occur at a future date is a contingent liability and not a liability in praesenti. It cannot be treated as a debt owed at the end of each accounting year. This being so, an employer can meet this liability in various ways. He may just meet it as and when it arises. But a prudent trader would like to place himself in a position to be ready to meet it when it arises. For this purpose, he may set aside each year such amounts as he can afford out of the profits so as to constitute a fund out of which the demands would be met when they arise. This method would be unsatisfactory in that the ad hoc amounts which he chooses to set apart may prove totally inadequate in certain circumstances : for instance, the tenure of the employees may be such that, all of a sudden, in one year most of them might retire causing unexpectedly heavy burden on the employer. To meet such a situation, an employer may undertake an assessment of the present value of his future liability on a scientific or actuarial basis and charge against the profits of each year such amount as would enable him to meet these demands when they arise. Southern Railway of Peru [1957] 32 ITR 737 and Metal Box : (1969)ILLJ785SC have approved of this procedure for income-tax purposes and for other purposes such as computation of bonus wherein profits of each year have to be understood in a commercial sense. Thus, where an assessed on some scientific or actuarial basis estimates the present value of the future liability and debits it to the P & L account, such an estimate can be allowed as a deduction and would be chargeable against the profits both for income-tax purposes as well as for the purposes of the Bonus Act. However, it is not always necessary to insist on a scientific or actuarial assessment. In the case of a small employer and a comparatively simple scheme of gratuity under which the gratuity is payable in almost every case and the possibility of an employee not being entitled to gratuity is very uncertain or remote, the employer may credit to the account of each employee and charge against each year's profits a portion of the salary of the employee on the basis of which he is entitled to gratuity and claim it as a deduction. In these cases, though some decisions have referred to a present liability having arisen or accrued, the true principle seems to be that the deduction is permissible, not on this ground, but on the ground that the true commercial profits cannot be arrived at without such an allocation. In income-tax language, it is an item to be taken into account in the ascertainment of profits under s. 28 of the I.T. Act, 1961, and not a deduction claimed or permissible under ss. 29 to 37 after arriving at the figure of profits. This principle appears sufficiently from the observation of Shelat J., in the Metal Box case : (1969)ILLJ785SC .

30. It is in the light of the above principles that the question in the present case has to be decided. Before us both parties have proceeded broadly on the basis of the definitions of 'provision' and 'reserve' enunciated by the Supreme Court in Metal Box case : (1969)ILLJ785SC . Under these definitions, if any amount is retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy it would amount to a provision and not a reserve. It is contended on behalf of the revenue that the expression 'known liability' in the above passage means any liability, whether present or future, the existence of which is known to the assessed. In other words, according to the department, it does not matter whether the liability is a present liability or a future liability. Even if amounts are set apart in respect of a purely contingent liability which may or may not mature, the amount so set apart would be only a provision. Counsel for the department points out that the decided cases show that a liability to gratuity is one in respect of which it is possible even to ascertain the amount with substantial accuracy as in the Metal Box : (1969)ILLJ785SC or the Delhi Flour Mills' cases : [1974]95ITR151(Delhi) and so an assessed cannot claim the amounts set apart in respect of that liability to be a reserve, at least to the extent of such discounted figure.

31. On the other hand, on behalf of the assessed, the stand taken is that the expression 'known liability' means a liability known to exist as at the relevant date, in other words, a liability in praesenti. The liability in respect of gratuity is only a future liability, except to the extent the employer is called upon to make payments to employees who actually retire or resign. At worst, perhaps, it can be said, though it is a future liability, that where an assessed has ascertained its present value on a scientific, actuarial or other acceptable basis, he can be said to be providing for a known liability the amount of which has been ascertained and that, thereforee, the amounts set apart cannot be said to be 'reserves'. It is pointed out that in the Metal Box case : (1969)ILLJ785SC as well as in certain other cases to which reference will be made later, the claim of the assessed was based upon amounts ascertained in a scientific manner as representing the present value of the future liability. In such cases alone, it is contended, it is open to an assessed to claim the amounts set apart as charge against the year's profits and to the department to treat the amounts set apart as provision. In all other cases, according to the assessed, the allocation being for a future contingent liability would be only in the nature of a reserve.

32. It seems to us that, in deciding the issue before us, it is necessary to bear in mind that the legislature has chosen not to define the word 'reserves' in this Act. It has, thereforee, to be interpreted very widely on the lines of the dictionary definition, as indicated in the Century case : [1953]24ITR499(SC) as connoting any amount held back or set apart for a specific purpose as at a relevant date. On this interpretation, it is of no consequence what that specific purpose is or how long it is intended to hold back the amounts. But, even it this meaning is considered to be too wide and one proceeds on the basis of the observations of the Supreme Court in Metal Box : (1969)ILLJ785SC , as providing a working definition, we think that the expression 'known liability', in the context of the Super Profits Tax Act, should be taken to refer only to a liability existing on the relevant date and not a future liability. We think so having regard to the nature and purpose of the legislation under consideration. The Business Profits Tax Act and the Super Profits Tax Act are pieces of legislation which operate on an annual basis. The purpose of ascertaining the capital is to work out the standard or statutory deduction available to an assessed by reference to the capital and reserves employed by the company in the business in the year of account. Having regard to the fact that this is an annual feature, it appears reasonable to say that what is relevant for the purposes of the computation are amounts which will be in the coffers of the company for a substantial period of time and are not likely to be frittered or taken away within a short while, if not within the year itself, or within a short period thereafter. For example, where amounts are set apart for payment of income-tax which is a liability in praesenti they would be only in the nature of a provision, for, the liability has already arisen and the amount would have been charged straightaway to the profit and loss account but for the fact that the amount is not definitely known. Or, if, as in Century Spinning's case : [1953]24ITR499(SC) and the Punjab & Haryana High Court case in CIT v. Hindustan Milk Food Mfg. Ltd. , the amount is not really held back at all but is on the contrary distributed within a month or so it may not be treated as a reserve. On the other hand, where the purpose of withholding the moneys is to meet a demand which may arise only in the future, it appears reasonable to hold that the amounts constitute 'reserves'. For instance, where a company has borrowed a large sum on money but which is repayable only after a period of 20 years and amounts are set apart by the company from year to year to meet this future liability the funds though set apart in the accounts would continue to be employed in the business for years together and it would be most inappropriate to call it a provision, as would follow if the contention of the department were accepted. If, in such a case, the company never set apart any sum towards the future liability and merely added to its general reserves, then the liability cannot be deducted in the computation of the capital of the company and it would be illogical, merely because the company set apart year after year some amounts out of its profits to meet the future liability, to treat the amounts set apart as mere provisions and not as reserves. We think that, as rightly pointed out by Shri Desai, counsel for the assessed, the correct test would be whether the amount is set apart towards items whose nature can be described truly as a charge against the annual profits of the company or whether the amounts so set apart continue to be under the proprietorship of the company and capable of being disposed of by it as it likes. In this context, we should not go by the definition in the schedule to the Companies Act. For one thing, unlike the Surtax Act which makes a reference to that definition, the Super Profits Tax Act avoids the incorporation of the said definition and since the Companies Act was of 1956, this must be taken to be deliberate. That apart, the purpose of the definition in the Companies Act is much wider and intended to safeguard the shareholders by ensuring that all possible liabilities of the company are provided for, as provisions to the extent of all known and foreseeable liabilities and as reserves to the extent of unforeseen and unknown liabilities. That special definition may not, thereforee, be imported here, particularly having regard to the object and purpose of the Act as explained earlier. We are, thereforee, of the opinion that the expression 'known liability' should be construed as a reference to liabilities in praesenti and not future liabilities.

33. This takes us to a consideration of the second aspect of the matter urged on behalf of the department. The argument is that Metal Box case : (1969)ILLJ785SC establishes the principle that the present actuarial valuation of the future liability could be treated as a charge on profits and that, thereforee, whether an assessed makes such a valuation or not in making up its accounts, amounts set apart for meeting gratuities to the extent of such actuarial estimated value can be treated only as provisions and only to the extent the amounts exceed such estimate, can they be treated as a reserve. The argument is attractive but, in our opinion, cannot be accepted for two reasons. In the first place, we have tried to explain that even in such a case, there is no creation of a liability in praesenti and if we are right on that, no further question arises in view of the definition of 'provision' we have adopted. But even if in such a case the creation of a liability in praesenti can be assumed, it will not help the department. What is a provision and what is a reserve have to be decided on the basis of the actual treatment accorded by an assessed to certain amounts in its accounts. Metal Box : (1969)ILLJ785SC was dealing with a case where actually the company had chosen to take current steps to meet the future liability by estimating its present commitment in regard thereto. It only lays down the proposition that it is open to an assessed to maintain its accounts in that way and what it would be commercially prudent to charge the annual profits with such amounts so as to be in a position to meet the liability as and when it arises in future. So an assessed does not change the nature of the amount, if instead of charging it against profits, he sets it apart out of the profits and such an allocation can be rightly treated as a provision, for, truly speaking, it should even have been deducted in arriving at the true profits. But we do not think any assessed can be compelled to make up his accounts in that particular way or make any such scientific provision for the future. It can choose to merely set apart ad hoc sums of money towards the same which may or may not be sufficient to meet that liability in future. Such an allocation cannot be treated as a provision. In the present case, the assessed has not made any allotment or allocation on the principles referred to earlier. It is merely an ad hoc allocation of a certain sum of money which is shown in the books as gratuity reserve. This is a part of the general funds of the company and held by the company for its future use. All that the company means by transferring it to the gratuity reserve account is that this is a sum of money out of the profits which the company holds for future use in relation to the gratuity payable to the employees. This is not a 'provision' in respect of a present charge against the profits of the company. The AAC has found that no part of the gratuity reserve has been allowed as a deduction and if necessary, this aspect can be got verified again. So long as the assessed has not estimated the current liability and set it apart or charged it to the current year and claimed a deduction thereforee for purposes of income tax, it cannot be said that a provision has been made by it towards an existing liability as understood in the above decisions.

34. We have discussed the issue on general principles as it comes up for consideration for the first time before this court. But, actually, this question has come up for consideration in a large number of judicial decisions and it appears that, except the Andhra Pradesh High Court, all the other High Courts have taken an almost unanimous view on this matter on more or less the same lines as we have indicated above. We shall mainly refer in brief to such of these cases as deal with allocations in respect of gratuity :

(a) The Allahabad High Court in CIT v. British India Corporation (P.) Ltd. : [1973]92ITR38(All) was dealing with various types of allocations which, however, did not include one towards gratuity. The court held that where an amount is set apart to meet a future liability, it is called a reserve and when set apart to meet an existing liability it is to be called a provision. The definition, quoted from Advance Accounting by R. Keith Yorston, is apposite [1973] 92 ITR 40 :

'It is recommended that the item to be described as a reserve should include amounts set aside out of profits and other surpluses which are not intended or necessary to meet any liability, contingency or diminution in value of assets, known to exist at the date of the balance sheet. On the other hand, the terms 'provision' should be used to describe any amount charged against current revenue or set aside out of the profits or other surpluses of a prior period to provide for a specific commitment or contingency of a revenue nature or diminution in value in assets on the date of the balance-sheet, the amount of which cannot be determined with substantial accuracy.' (b) The Madras High Court in CIT v. Indian Steel Rolling Mills Ltd. : [1973]92ITR78(Mad) held that 'amounts set apart for payment of gratuity, a contingent and future liability, and which have been used for the purposes of the business of the company' should be treated as a 'reserve' within the meaning of the Act. The court referred to its earlier ruling in CIT v. Vasantha Mills Ltd. : [1957]32ITR237(Mad) , under the Business Profits Tax Act, wherein amounts set apart for payment of income-tax and excess profits tax were held to constitute reserves. This decision was also followed in Mettur Industries Ltd. v. CIT : [1978]114ITR439(Mad) , which lays emphasis on the fact that the addition to this account year after year was by way of lump sums and not on the basis of any ascertained amounts.

(c) The Kerala High Court in CIT v. Periakaramalai Tea & Produce Co. Ltd. : [1973]92ITR65(Ker) has also taken the view that a fund created for payment on retirement of gratuity to the employees of a company is not for any commitment which has already arisen or payment of which has fallen due but is only a provision in regard to the gratuity which may have to be paid to the employees as and when the liabilities may arise in future and that the funds so created would be 'other reserves' within the meaning of r. 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964. In this connection, it may be mentioned that the High Court, following the Metal Box's case : (1969)ILLJ785SC , has in CIT v. High Land Produce Co. Ltd. : [1976]102ITR803(Ker) held that the actuarial present value of the contingent liability towards gratuity is allowable as a deduction for income-tax purposes.

(d) The Bombay High Court in the context of s. 23A of the Indian I.T. Act, 1922, had treated the liability towards gratuity as an accrued liability where the provision had been made in respect of the gratuity payable to its employees who had already completed ten years of service (see Greaves Cotton & Crompton Parkinson Ltd. v. CIT : [1963]48ITR20(Bom) . More recently, it had occasion to discuss this issue at length in its decision in CIT v. Forbes Forbes Campbell & Co. Ltd. : [1977]107ITR38(Bom) , on which Mr. V. S. Desai, counsel for the assessed, has placed very strong reliance. In that case, as in the present one, there was no approved gratuity scheme framed as such by the assessed-company and the company had not undertaken any actuarial valuation or made any attempt to estimate the present commitment for the future liability. The court, after referring to Metal Box : (1969)ILLJ785SC , observed (at. p. 42) :

'From the aforesaid observations the principle which is deducible is, though ordinarily appropriations to gratuity reserve are to be regarded as contingent liabilities, if on actuarial basis the estimated present liability could be ascertained properly, then, such ascertained estimated present liability could be allowed as a deduction while computing the profits of a business. On the other hand, if appropriation have been made to gratuity reserve without undertaking any actuarial liability or discounting the present value, then obviously the appropriations cannot be regarded as a provision made by way of providing for any known or existing liability. In the instant case, as we have observed earlier, there is no dispute before us that there was neither the scheme of gratuity framed and got approved by the assessed-company under which the amounts were set apart towards gratuity reserve nor was scientific or actuarial valuation undertaken by the assessed-company. The three amounts which stood credited to the gratuity reserve, thereforee, as on the material date, being the first day of the previous year relevant to the three assessment years will have to be regarded as amounts having been set apart not designed to meet any known or existing liability and as such will have to be regarded as reserve.' The Bombay High Court dissented from the Andhra Pradesh decision in Vazir Sultan : [1974]96ITR248(AP) later referred to.

(e) The Gujarat High Court has also taken the same view in CIT v. Joti Ltd. : [1978]112ITR973(Guj) . The Tribunal in that case had found that the gratuity reserve was merely an amount kept back for future years without any reference to ascertained liability. There was no actuarial valuation and there was no case of a provision being made for anticipated known liability and, thereforee, it was held to be in the nature of a reserve includible in the computation of the capital. The Gujarat High Court approved the view taken by the Tribunal referring to its own earlier decision in CIT v. Mafatlal Chandulal & Co. Ltd. : [1977]107ITR489(Guj) .

(f) The Calcutta High Court has taken the same view as in the above cases in three decisions, namely, CIT v. Burn and Co. Ltd. : [1978]114ITR565(Cal) , CIT v. Indian Standard Wagon Co. Ltd. : [1979]116ITR539(Cal) and CIT v. Indian Standard Wagon Co. Ltd. : [1979]118ITR623(Cal) . The court has relied on the observations of the Bombay High Court in Forbes Forbes Campbell's case : [1977]107ITR38(Bom) .

(g) The Patna High Court, in its recent decision in Heckett Engineering Co. v. CIT : [1979]120ITR417(Patna) , appears to have gone further than the above cases and held that an allotment can be said to be a provision only where it is made against an existing demand and that it was not sufficient to say that it is an allocation against an existing liability. Thus, allocation towards dividend already declared by the company was treated as a provision being towards an existing demand; but amounts set apart towards income-tax, where there was no existing demand, were treated as reserves. S. P. Sinha J., after referring to some decision which had held that even an allocation towards an existing liability to be reserve and cleavage of judicial opinion as to whether it would be so held, observed (at p. 431) :

'It cannot be denied that the setting apart of a sum to meet the taxation liability is an amount set apart to meet a debt which has to be paid out of the amount set apart.

The question however, is not that the amount so set apart is at some point of time to be paid out, but the question involved is whether having set apart that amount for a particular purpose, it could still form a 'reserve' for the purpose of computing the capital base of a company as on a particular date. It has to be borne in mind that the computation is required to be made having regard to the state of affairs as present on the first day of the accounting year relevant for the assessment in question. If on this date a certain reserve has been created, though for the purpose of meeting a liability which is sure to arise, but which has not arisen. I do not see as to how the company could be deprived of the benefit of using that sum towards its capital base. One can understand the exclusion of such amounts from being reckoned toward the capital base against which a demand has already arisen 'for example' where a provision has been made for payment of dividend, the dividend having already been approved by the shareholders at their meeting. The reserve created for the purpose of payment of dividend in such circumstances will not qualify to be reckoned as reserve for the purpose of computing capital base as on the first day of the relevant accounting year. There is a clear distinction between an 'existing liability' and an 'existing demand'. For example, although a sum is required to be paid out but as to when it is required to be paid is not specified, and if a reserve has been created towards that liability, it can be called a reserve towards an 'existing liability', but it is not the same thing as a reserve towards an 'existing demand'. If this difference is borne in mind the distinction between an existing liability or 'debt owed' and an existing demand or a demand for payment is easily understandable. One can understand a case where an amount has been paid out even towards advance payment of tax as not being a reserve for the purpose of capital computation. As was held by the Gujarat High Court in the case of Rohit Mills Ltd. : [1965]58ITR854(Guj) or by the Madras High Court in the case of Nagammal Mills Ltd. : [1974]94ITR387(Mad) and the Calcutta High Court in the case of Indian Steel and Wire Products Ltd. : [1958]33ITR579(Cal) , if an amount is paid out, certainly it cannot be available for the purpose of forming the capital base. As is the oft-quoted phrase, one cannot have the cake and eat it at the same time. I am, thereforee, unable to accept the view that merely because it is a 'debt owed' or it is an 'existing liability', a provision made towards it in the shape of reserve will not qualify to forming a capital base as on a particular date.'

(h) The only dissenting voice in the above consensus of judicial opinion is that of the Andhra Pradesh High Court in the case of Vazir Sultan Tobacco Co. Ltd. v. CIT : [1974]96ITR248(AP) reiterated in a Full Bench decision of the same High Court in Hyderabad Asbestos Cement Products Ltd. v. CIT : [1976]105ITR822(AP) . In the Vazir Sultan case, the court was concerned with amounts set apart for taxation, retirement gratuity and dividends and these were held to constitute provisions and not reserves. After referring to definitions of these expressions in the Companies Act, in the decision of the Supreme Court in Metal Box case : (1969)ILLJ785SC and in standard works on accountancy, the court came to the conclusion that the amount of gratuity payable to a worker is known and could be worked out with substantial accuracy and that, thereforee, it should be treated as a mere provision and not as a reserve. Before the Full Bench [Hyderabad Asbestos Cement Products Ltd. v. CIT : [1976]105ITR822(AP) ] an attempt was made to argue that certain observations in the earlier decision ran counter to the decision of the Supreme Court in Kesoram Mills' case : [1966]59ITR767(SC) . But this contention was repelled. The court held, inter alia, that 'provisions made against anticipated contingencies and losses' could not be treated as reserve but the case did not concern a 'gratuity reserve'. These two decisions on doubt give a wide meaning to the expression 'known liability' but, for reason already discussed, we do not think this is justified in the context of the Super Profits Tax Act.

35. For the above reasons, we would follow the majority of decisions on this subject and hold that the amounts set apart by the assessed to meet its liability for gratuity will be a reserve, as such setting apart has not been the result of an ascertainment by it of the present value of such future liability. The Tribunal was right in coming to the conclusion that the sum of Rs. 3,35,000 represented 'reserves' which should be treated as part of the capital for the purpose of the Super Profits Tax Act. The question referred to us is answered in the affirmative and in favor of the assessed.

37. But, having regard to the fact that the reference involves a difficult issue, we are of opinion that the parties should bear their own costs.


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