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Addl. Commissioner of Income-tax, Delhi-i Vs. Minerals and Metals Trading Corporation of India Ltd. - Court Judgment

LegalCrystal Citation
SubjectDirect Taxation
CourtDelhi High Court
Decided On
Case NumberIncome-tax Reference No. 150 of 1972
Judge
Reported in(1981)25CTR(Del)228; [1982]134ITR78(Delhi)
ActsC (P) ST Act, 1964 - Schedule - Rule 1; Companies Act, 1956 - Schedule - Rule 7; Income Tax Act, 1961 - Sections 34(3)
AppellantAddl. Commissioner of Income-tax, Delhi-i
RespondentMinerals and Metals Trading Corporation of India Ltd.
Excerpt:
direct taxation - reserve - section 34 (3) of income tax act, 1961, rule 1 of schedule to c(p) st act, 1964 and rule 7 of schedule 6 to companies act, 1956 - assessed set apart certain amount for expected statutory liabilities in near future - whether disputed amount 'reserve' within meaning of act - there should not be any liability against amount set apart in order to come within purview of expression 'reserve' - neither there was any liability on relevant date nor apprehension of liability in near future against amount set apart - disputed amount can be maintained as reserve. - - and (7) other items of welfare sanctioned from time to time and considered to be beneficial for the general well being of the employees subject to the approval of the managing director. 11. the next item.....ranganathan, j.1. these two references arise under the companies (profits) surtax act, 1964 (hereinafter referred to as 'the act'), and involve the much debated question whether certain sums set apart by the respondent constituted 'reserves' within the meaning of r. 1 of sch. ii to the act. 2. the assessed is a public sector corporation carrying on the business of import and export of minerals and metals. it is incorporated as a company under the companies act. for the assessment years 1966-67 and 1967-68 the assessed claimed that the following amounts, which were shown in the balance-sheet of the corporation for the relevant years as on april 1, 1965, and april 1, 1966, respectively, constituted reserves which should be added to the capital base of the company for determining the.....
Judgment:

Ranganathan, J.

1. These two references arise under the Companies (Profits) Surtax Act, 1964 (hereinafter referred to as 'the Act'), and involve the much debated question whether certain sums set apart by the respondent constituted 'reserves' within the meaning of r. 1 of Sch. II to the Act.

2. The assessed is a public sector corporation carrying on the business of import and export of minerals and metals. It is incorporated as a company under the Companies Act. For the assessment years 1966-67 and 1967-68 the assessed claimed that the following amounts, which were shown in the balance-sheet of the corporation for the relevant years as on April 1, 1965, and April 1, 1966, respectively, constituted reserves which should be added to the capital base of the company for determining the statutory deduction under the Act:

As on 1-4-1965 As on 1-4-1966Rs. Rs.1. Staff benefit reserve 67,854 1,25,7322. Self-insurance reserve 7,08,696 14,98,8783. Staff bonus reserve nil 13,31,893

3. The ITO was of the opinion that the above three items were in the nature of 'current liabilities and provisions' and could not, thereforee, be treated as 'reserves'. The AAC agreed with this view. But, on further appeal, the Tribunal held that the amounts were 'reserves'. At the instance of the Commissioner, the following questions have been referred to us for our decision:

4. For the assessment year 1966-67:

'Whether, on the facts and in the circumstances of the case, the Tribunal was correct in law in holding that the accounts styled as 'staff benefit reserves' and 'self-insurance reserve' were outside the scope of the Explanationn to rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964, and the amounts standing to the credit thereof constitute reserves within the meaning of the said Schedule ?'

5. The Act presently under consideration replaced the Super Profits Tax Act, 1963. Broadly, the pattern of the two Acts is the same but there are some minor differences. The 1963 Act brought to tax the super profits of a company by which was meant the excess of its chargeable profits of a previous year over the standard deduction. The chargeable profits were profits made by the company during the relevant previous year as determined for the purposes of income-tax with some adjustments, which it is un-necessary to consider here. The standard deduction was an amount equal to 6% of the capital of the company or Rs. 50,000, whichever was greater. The rules for a computation of the capital were set out in the Second Schedule. Rule 1 of the said Schedule, in so far as it is material for our present purpose, 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 (1) its paid-up share capital, (2) its reserves, if any, created under prov. (b) to clause (vib) of sub-s.(2) of s. 10 of the Indian I.T. Act, 1922 (11 of 1922), or under sub-s. (3) of s. 34 of the I.T. Act, 1961 (43 of 1961), (3) 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 purpose of the Indian I.T. Act, 1922 (11 of 1922), or the I.T. Act, 1961 (43 of 1961). There was no definition of the expression 'reserves' in this Act.

6. The 1964 Act also brought to charge the chargeable profits of a company in excess of the amount of statutory deduction provided for by the Act. Chargeable profits were computed in each previous year by making certain adjustments to the profits determined for income-tax purposes. Statutory deduction meant an amount equal to 10% of the capital of the company as computed in accordance with the provisions of Sch. II or an amount of Rs. two hundred thousand, whichever is greater. The rules for the computation of capital were laid down in Sch. II and r. 1 was on the same lines as the 1963 Act and defined the capital of the company as the aggregate of the amounts of its paid-up share capital and its reserves in the same language as the 1963 Act. However, an Explanationn was added in the following terms:

'Explanation. - 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. Neither the 1963 Act nor the Act presently under consideration contained a definition of the term 'reserve'. But the 1964 Act clarifies by means of a reference to the form of balance- sheet prescribed for companies under the Companies Act that an item which is displayed in the balance-sheet under the heading 'Current liabilities and provisions' would not constitute a 'reserve'. Similarly, it clarifies that an item displayed against items (5), (6) and (7) in the balance-sheet under the heading 'Reserves and Surplus' shall not also be treated as a 'reserve'. Items (5), (6) and (7) in the balance-sheet under the heading 'Reserves and Surplus' 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. Under the heading '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 dividend, for contingencies, for provident fund 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. Rule 7 of Pt. III of Sch. VI to the Companies Act also contains a definition clause. 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.'

9. A sub-paragraph appended to sub-clause (1) clarifies that the expression 'liability' used in the sub-clause shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities. Sub-clause (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 purpose of the Schedule as a 'reserve' and not as a 'provision'.

9. It is in the context of the above provisions of the 1964 Act that the questions in the present case have to be decided and it will be convenient at the present stage to briefly set out the nature of the three items of appropriations made by the assessed.

10. The first item is the staff benefit reserve. The management of the Corporation was setting apart a portion of the surplus every year under different heads and 'staff benefit reserve' was one of the heads under which such allocation was made year after year. This amount was kept aside for the implementation of various benefit schemes of the company. The Corporation had formulated a set of rules known as 'staff benefit rules' for regulating the expenditure on different welfare schemes. Such rules were quite detailed and provided for various kinds of expenditure on welfare scheme such as: (1) grant of educational allowance to the children of the corporation's employees; (2) grant of scholarships to deserving children of the employees; (3) relief to the members of the staff and their families in case of distress not admissible under the normal rules; (4) grant in aid for sports and recreation clubs; (5) establishment of family welfare centres for giving training in tailoring, embroidering and other arts to members of the employees' families; (6) establishment of departmental/co- operative canteens and stores; and (7) other items of welfare sanctioned from time to time and considered to be beneficial for the general well being of the employees subject to the approval of the managing director.

11. The next item is the 'staff bonus reserve'. This was an allocation made in order to enable the company to discharge its statutory liability under the Bonus Act, 1965. Bonus payments are to be made by an employer to its employees out of the 'allocable surplus' of the profits of the year, determined in accordance with well established principles. The Bonus Act apart from defining 'allocable surplus' made certain modifications in the general principles that were being applies in industrial law. In the first place, s. 10 of the Act laid down that whether the employer has an allocable surplus at all or not, each eligible employee should be paid a minimum bonus of four per cent. of the salary. Secondly, it provided that the bonus payable should be increased above 4% where the allocable surplus was more than the amount necessary for the payment of the minimum bonus. The bonus payment was to be proportionately stepped up, where the allocable surplus permitted it, up to a maximum of 20% of the salary. Thirdly - and this is what is material for our present purpose - the statute at the relevant time contained a set-off/set-on provision by which the shortfall of the allocable surplus in any year below the amount necessary for distribution of the minimum bonus could be set off against the surpluses available in a subsequent year; and likewise, the surplus left over after the distribution of the maximum bonus for any year could be set on and added to the surpluses available in a subsequent year to declare a higher bonus. Such carry forward for set off or set on was envisaged for a period of four accounting years. The practical application of this principle which has been modified in certain aspects by an amendment of 1976, with effect from September 25, 1975, with which we are not concerned, has been illustrated in the Fourth Schedule (now the Third Schedule) to the Act. The company, thereforee, set aside out of its profits certain sums representing the 'set on' that would be necessary to meet a possible deficiency of profits in a future year when it may be required to distribute the minimum bonus despite the absence of sufficient profits.

12. The last item in dispute is the 'self-insurance reserve'. The Corporation was operating a scheme of self-insurance to economies on insurance charges. The Corporation was importing various commodities from abroad and it had to insure the same against loss in marine transit. A comprehensive insurance of all the commodities for their full value with insurance companies against all risks was considered to be uneconomical. The Corporation, thereforee, insured the commodities only against limited risks but at the same time considered it wise and prudent to provide for possible losses that may arise and that may not be covered by the insurance policies taken by it. Every year, thereforee, the Corporation set apart same amounts at a fixed rate with a view to meet any marine loss in transit over and above those covered by regular insurance. A comprehensive scheme had been framed with the approval of the board of directors and 'insurance premium' calculated at a particular rate on each import consignment was debited to the profit loss account and credited to the 'reserve' account.

13. So far as the 'staff benefit reserve' is concerned, the AAC took the view that as the disbursement of funds on the several welfare schemes was governed by elaborate rules, it was open to the employees of the Corporation to insist upon expenditure being incurred on their welfare, even though there was no statutory liability for the Corporation to do so. He felt that this was covered fully by item 12 of the items listed under the sub-head 'Current Liabilities and Provisions' in the form of balance-sheet. In regard to the 'staff bonus reserve' he was of the view that the provision had been made in pursuance of a statutory liability under the Bonus Act which would at best be called a contingent liability. The fact that these amounts were debited to the profit and loss account also showed that they were in the nature of provisions for contingent liabilities and not appropriations to reserves from the appropriation account. In regard to the insurance reserve he found that the accumulations in this account were earmarked for a particular liability which could arise at any time depending upon loss in a particular consignment. The amounts credited to this reserve were provisions against liabilities dependent on the happening of a contingency in future and it would not be correct to call them reserves.

14. On the other hand, the Appellate Tribunal was of the opinion that the amounts set apart under the head 'Staff benefit reserve' could not be said to be amounts set apart for any known liability of which the amount could not be determined with substantial accuracy. So far as the 'staff bonus reserve' was concerned, the Tribunal pointed out that there was no definite liability on the part of the company in this respect in the year under consideration and that unless and until some deficiency of profits arose in a subsequent year there would be no liability on the part of the Corporation to distribute a bonus and so this amount was also a reserve and could not be treated as a provision. So far as the third item was concerned, the Tribunal was of the opinion that despite the fact that there was a scheme formulated, the accumulations in the account did not partake of the nature of liabilities as there was no known liability against the Corporation for the amounts in question and, thereforee, they could not be treated as liabilities but could be treated only as reserves.

15. We think that there can be no doubt at all that the conclusion of the Tribunal was clearly right in so far as the amounts set apart for the 'staff benefit reserve' and 'self-insurance reserve' were concerned. Though the form of balance-sheet prescribed under the Companies Act refers to provisions for insurance and staff benefit schemes for inclusion under item 12 under the sub-head 'Current Liabilities and Provisions', the question whether any particular item has to be listed under the 'Current Liabilities and Provisions' or not has to be decided in terms of the definition contained in r. 7 of Pt. III of Sch. VI to the Companies Act to which reference has been made earlier. A provision in respect of self-insurance, bonus and similarly staff benefit schemes can come under the above heading only if it is capable of being described either as a current liability or as a provision, i.e., as a liability which exists on the date of the balance-sheet or as an item of amount retained by the company by way of providing for any known liability, of which the amount cannot be determined with substantial accuracy. In either case, there should exist a liability, though it could be a disputed or contingent liability, as contemplated in the above rule. However, so far as these two items are concerned, we are unable to see any liability on the part of the company for which it is at all necessary to make any provision, 'whether current' or otherwise. So far as the staff benefit schemes are concerned, the relevant rules have not been placed before us. But it appears clear from the details appearing in the record that there is no liability on the part of the corporation to incur any expenditure in this respect. The company has no doubt several schemes for the benefit of the employees and no doubt the company is also utilising the money set apart under this head for the benefit of the employees. But the finding of the Tribunal is that there is no obligation on the part of the company towards its employees to spend the monies for the benefit of any particular employee. There is no commitment on the part of the company that any or all the amounts set apart in this account would or should be spent only towards the benefit schemes. There is no material placed before us to show that the rules, in accordance with which the funds in reserve are distributed, are binding on the corporation vis- a-vis its employees. On the other hand, the items of welfare schemes, some of which have been referred to earlier, would show that the application of money is purely discretionary on the part of the company. Thus, e.g., while the company could grant scholarships to deserving children of the employees, none of the employees would be in a position to insist that his child should receive a scholarship from the company. Similarly, while the fund will be utilised to relieve distress in the case of any member of the staff or his family, the relief is provided for only in cases where it is not admissible under the normal rules. There is no claim on the part of the staff by which it could insist that the monies should be given in any particular case. So also the grant in aid for sports and recreation clubs is a matter of disbursement at the will and pleasure of the corporation. In other words, though the company has built up a fund for the benefit of various employees of the company and though the company has also formulated for its own guidance various schemes and rules according to which amounts would be given out of this fund, there is no corresponding right on the part of any employee to claim as of right any funds out of this appropriation. Per contra there is no liability whether present or future not the part of the company to spend the money in any particular way for the benefit of any particular employee. The fund set apart in this account cannot, thereforee, be described as a fund to meet any known liability, present or even future. They are clearly funds accumulated by the company from time to time out of its profits with a view to spent for such advantage of the employees as the company might choose in accordance with certain well- defined policies. They cannot be described as provisions.

16. The 'self-insurance reserve' is also in an analogous position. The Corporation while importing its consignments is not obliged to insure them against all risks conceivable during a marine transit. The Corporation found it uneconomical to insure the goods against all possible contingencies. It, thereforee, limited the insurance to certain types of risks but against possible future losses or difficulties. The Corporation also made a prudent allocation out of its profits. It calculated a certain amount in respect of each import consignment and debited the corresponding amount to the profit and loss account and credited it to the reserve account. This was only a fund built up by the company to enable it to offset future losses; that may arise due to in pilferage, etc., in the case of marine transit of the goods which may not be adequately covered by the insurance. There is no obligation on the part of the company either to incur the expenditure by way of insurance nor is the company liable to any third party in respect of any pilferage that may occur during transit which is not covered by the insurance. These are merely fund built up by the company to safeguard itself against losses that may arise on account of the insurance cover not being adequate. This against is not a provision against a liability of the company, whether present or future. We are, thereforee, in agreement with the Tribunal that this would also constitute only a setting apart of certain funds otherwise than by way of providing for any known liability and the Tribunal was right in holding that the amounts standing to the credit of this account represented reserves as on the relevant dates.

17. That leaves the question of the bonus reserve. In order to understand this, one has to refer to s. 11 of the Bonus Act. From the provisions of the Bonus Act referred to earlier, it will be seen that the company was providing against the contingency of its being required to pay the minimum bonus in a year in which there are not sufficient profits and also building up a fund which would enable the company to utilise the surpluses thus carried forward to distribute a large or the maximum bonus in respect of any year. In so far as the reserve is being set apart to enable the assessed to meet the contingency of its being compelled to distribute a bonus despite the loss of profits in that year, the amounts credited to this account can be described as amounts set apart to meet a future contingent liability the exact amount of which cannot be ascertained with substantial accuracy at the date of the balance-sheet. It can, thereforee, be urged that the amounts set apart under this head would not fall within the meaning of the expression 'reserve' contained in the Companies Act particularly having regard to the extended meaning of the word 'liabilities' as set out in sub-clause (3) of r. 7 of Pt. III of Sch. VI to the Companies Act.

18. Sri Desai, learned counsel for the Corporation, sought to get out of this situation by raising two contentions. His first contention was that the Explanationn to r. 1 of Sch. II to the Act covers only a case where certain amounts stand to the credit of an account described as 'current liabilities and provisions' in the balance-sheet of the company and not to a case where the amount or amounts are shown under the heading 'reserve' in the company's balance-sheet. The second point urged by him is that even assuming that it is not the description or the manner of depiction by the assessed in the balance- sheet that is material but the real nature and substance of the allocation determined in accordance with the definition contained in Pt. III, the amounts in question still do not constitute 'provision' because they are not set apart to meet any known liability. The contention of Shri Desai is that while the word 'liability' is defined to include both disputed and contingent liabilities, full significance should be attached to the word 'known' that is used in the definition. This according to him means existing as at the date of the balance- sheet. He submits that as on the date of the balance-sheet there should exist a liability whether it is an accrued liability or a disputed liability or a contingent liability. But such a liability should not on the date of the balance-sheet be purely in the realm of the unknown. To give an example he points out, if there is a guarantee deed executed by the company in respect of loans taken by the directors there would, in a sense, be a contingent liability against the company the moment such a deed is executed, for, the possibility of the debtors defaulting or the creditors proceeding against the company cannot be ruled out. However, he points out that a provision in that regard needs to be made in the balance-sheet only when some director has committed default or conducted himself in such a manner that the liability under the guarantee may, to the company's knowledge, be sought to be enforced against the company. In such a situation, the liability though not determined by any appropriate authority and though disputed or contingent has to be provided for. But where all that has happened is that the company had executed a deed of guarantee and there is a possibility, some day in future, of a liability being fastened on the company eventually, according to the counsel, even if any amount is provided for in the balance-sheet towards such possibility, it would still be only a 'reserve'. In other words, the attempt of the learned counsel is to restrict the expanded meaning given to the word 'liability' by placing emphasis on the use of the word known in the manifesto of the definition.

19. In support of his first contention, Mr. Desai relied observations in the decision of the Bombay High Court in CIT v. Otis Elevator Co. (India) Ltd. : [1977]107ITR241(Bom) , the learned judges observed that the Explanationn to r. 1 of Sch. II to the 1964 Act was only for the removal of doubts and not that, in order that the Explanationn should apply, it should be shown that, in the balance- sheet of the company for the relevant period, certain items falling under the heading 'Current liabilities and provisions' have been shown in the column relevant to 'liabilities' in the form of balance-sheet or that the items are to be of the nature of item 5 or 6 or 7 falling under the heading 'Reserves and Surplus'. The court pointed out that the item of Rs. 53,338.55, which was in issue before the court, did not at all appear in the column of liabilities in the balance-sheet for the relevant year but appeared under the heading 'Reserves and Surplus' and as such the question of applying the Explanationn to the facts of the case did not arise. Here, it seems to us, and we say so with respect, that the court was under a slight mis-apprehension regarding the interpretation of the Explanationn in the context of the form of balance-sheet prescribed under the company law, for, any item shown in the balance-sheet under the head 'Reserves and Surplus' is an item that will automatically fall in the column relating to liabilities in the form of balance-sheet, as a glance at the balance- sheet would show. The 'liabilities' column referred to in the Explanationn should not be mixed up with the heading of 'Current Liabilities and Provisions' appearing in that column which is certainly distinct from the heading of 'Reserves and Surplus' which is also shown under the same column. We, thereforee, do not think that it would be correct to say that an item which appears under the heading 'Reserves and Surplus' does not occur in the column of liabilities at all in the balance-sheet. However, the Bombay High Court also held that the item in the question before it was not of the nature of item 5, 6 or 7 under the heading 'Reserves and Surplus' or of any of the items appearing under the heading 'Current Liabilities and Provisions' and hence this decision does not help Sri Desai.

20. Shri Desai also invited our attention to the decision of the Calcutta High Court in CIT v. Indian Standard Wagon Co. Ltd. : [1979]116ITR539(Cal) , it was pointed out that the item in question with which the court was concerned did not fall under any of the heads mentioned in the sub-heading 'A' under 'Current liabilities'. It was pointed out that in the form of balance-sheet 'Current liabilities' and 'Provisions' were separately treated, the former being classified under the sub-heading 'A' and 'provisions' being classified separately under the sub-heading 'B'. The court then proceeded to observe that what is excluded by the Explanationn from being treated as reserve is not anything which is included in the sub-heading 'Provision' but only those items which are included under the heading 'Current liabilities'. It was, thereforee, held that an amount falling under item 13 or 10 under the heading 'Provisions' did not really fall for exclusion in the computation of reserve under the Explanationn. Here also, if we may say so with respect, there appears to have been the same misapprehension regarding the scope of the Explanationn arising out of a mix-up between the expression 'liabilities' - which refers to one of the two columns of the balance-sheet-and the expression 'current liabilities' which is a sub-heading under a heading falling under that column. As we read it, the Explanationn takes in, for exclusion from the concept of 'reserve', all items shown under either of the two headings 'A' and 'B' of the heading 'Current Liabilities and Provisions'. The reference to the column relating to 'Liabilities' made a little later in the Explanationn is not a reference to the heading 'Current Liabilities' shown under the sub-heading 'A' but to the general column of liabilities as opposed to the column relating to assets in the form of balance-sheet. Once, thereforee, an item is recognised to fall under the headings 'Current liabilities' or 'Provisions' or is one of the stipulated items referable to the heading 'Reserves and Surplus', it would certainly be liable to be excluded from being treated as reserve. We, are, thereforee, unable to agree with these aspects of the two judgments relied upon by Sri Desai.

21. We are also unable with respect to agree with what has been referred to in the Bombay decision as the 'technical' approach which seems to suggest that the question whether an item is to be treated as a 'Current liability' or 'provision' or a 'reserve and surplus' should be decided on the basis of the manner in which it is exhibited in the balance-sheet. The Explanationn does not confine itself only to amounts shown in the books of the company under item 5, 6 or 7 of the heading 'Reserves and Surplus' or under the heading 'Current Liabilities and Provisions'. It empowers the ITO to enquire whether there is any amount shown in the balance-sheet which is of the nature of item 5, 6 or 7 under the heading 'Reserves and Surplus' or of any item under the heading 'Current Liabilities and Provisions'. The addition of these words 'of the nature of' inclines us to the view that what is to be considered is not whether the assessed has exhibited it under one head or another but whether in its nature any item standing to the credit of any account in the books of the company on the relevant date can be described as falling within the above categories.

22. thereforee, the argument that as the assessed has shown these items under the head 'Reserves and Surplus' and they are not of the nature of item 5, 6 or 7 under that head, they cannot be treated as provisions does not appeal to us. If an item is really of the nature of an item under the heading 'Current Liabilities and Provisions' it cannot be regarded as a reserve and in order to decide whether it is of the nature of a provision or not the ITO will be entitled to consider the definitions contained in Sch. VI to the Companies Act and come to a conclusion as to the head under which the item should be properly exhibited. If he comes to the conclusion that it is properly capable of being shown as a reserve other than items 5, 6 and 7, he can treat it as a reserve. But if he comes to the conclusion either that, though it is a reserve, it is of the nature of item 5, 6 or 7 there-under or that it is in the nature of a current liability or a provision, he cannot regard it as a reserve in view of the Explanationn. The first contention of the learned counsel is, thereforee, rejected.

23. The second contention raised by the learned counsel really calls for an interpretation of the expression 'known liability' used in r. 7 of Sch. VI to the Companies Act. If the allocation has been made for providing for a known liability the amount of which cannot be determined with substantial accuracy it will only be a provision. However, in view of the second sub-para. of r. 7(1), the expression 'liability' should be understood to mean all liabilities including disputed or contingent liabilities. Introducing this expanded definition of the word 'liability' in clause (1), an item will be in the nature of a provision if it is an amount retained by way of providing for any known present, future, disputed or contingent liability, the amount of which cannot be determined with substantial accuracy. The argument of the learned counsel is that though all liabilities, present or future, certain or contingent, admitted or disputed, can all be treated as liabilities for the purpose of this definition, the real emphasis in the definition has to be attached to the word 'known' used in cls. (a) and (b) of r. 7(1). Learned counsel contends that the introduction of this word qualifies the otherwise very wide scope of the definition and restricts it only to cases of provision for a liability, the existence of which is known, as on the date of the balance-sheet. In support of this contention, again, learned counsel refers to the Bombay decision earlier cited [1977] 107 ITR 241. At p. 250, the learned judges observed that although the expression 'liability' is defined as inclusive of contingent liabilities even so such contingent liabilities must be known contingent liabilities. That such would be the correct position in commercial accountancy, they point out, is clear from what has been stated in Standard Treatise on Auditing and Accountancy. Quoting a passage from p. 149 of Spicer and Pegler's Practical Auditing, 4th Indian Edn. it is pointed out, that contingent liabilities spoken of in r. 7(1) will be of the type referred to in the said passage, which may be conveniently quoted here:

'(12) Contingent liabilities. - The auditor should ascertain whether there are any transactions outstanding at the date of the balance-sheet which might involve the payment of money at some subsequent date. Such outstandings are termed 'contingent liabilities' and may be of two classes: the one involving a loss should the liability accrue, and the other involving the acquisition of an asset of corresponding value. It is sufficient for the amount of the contingent liability to be stated on the face of the balance-sheet by way of a note, unless there is a definite probability that a loss will materialise, when specific provision should be made thereforee. The most familiar instance is the contingent liability on bills receivable which have been discounted. If at the date of the balance-sheet any of the bills that have been discounted are outstanding, there will be a contingent liability in respect thereof, since if the acceptors do not meet the bills on maturity, the holders will have a right of recourse against the drawer or any prior indorser...Other instances of contingent liabilities which might involve a loss, should they accrue, would be damages and costs in the case of an action pending, forward contracts, guarantees for third parties, and speculative transactions on the stock exchange still undecided.'

25. Learned counsel submits that the expression 'known' imports the idea that as at the relevant date a transaction should have been completed or an event must have happened which renders the accrual of the liability definitely probable. This importance of the existence of some transaction or of some event having taken place has also been sought to be reinforced by a reference to the observations of the Kerala High Court in CIT v. Periakaramalai Tea & Produce Co. Ltd. : [1973]92ITR65(Ker) . In that case, the Kerala High Court was concerned with the question as to how far reserves for gratuity created by the company could be treated as 'reserves' within the meaning of the 1964 Act. After referring to the dictionary meaning of the expression 'reserve' and the decisions of the Supreme Court and certain other High Courts, the court held that in the case of gratuity no current liability had arisen in the accounting year and observed (p. 77):

'In regard to a liability which has not arisen (in the sense no doubt has become due from the assessed by reason of retirement) any amount reserved does not have the character of amount reserved by way of provision to meet a liability. The argument of counsel for the revenue is that even such a reserve is in the nature of liability mentioned in the heading 'Current liabilities and provisions'. It is easy to see that it is neither a current liability nor one in the nature of such liability. If 'provision' has to be understood in relation to a balance-sheet for the current year as one for meeting the liabilities of the year, as we feel it should be, it is evident that the disputed reserve is not in the nature of a provision. Counsel for the revenue argues that the term 'contingencies' referred to in the form of balance-sheet has not to be related to the year in question but to any liability that may arise at any point of time. In a balance-sheet where the financial position for the year is reflected and the liabilities as at the end of the year are shown, we see no reason to read the entries in the manner in which the counsel for the revenue wants us to read it. Apart from the fact that by its very nature a reserve such as one for retirement gratuity is not a reserve for meeting any liability that has already arisen, we see no reason to hold that the expression 'other money for which the company is contingently liable' in item 5 of the foot-note or 'for contingencies' as item 10 under the heading 'Provisions' means any liability that has not accrued and will not be, by its very nature, liability in the current year.'

26. We are of opinion that there is force in the contention of Shri Desai. Though the definition in r. 7 is very wide, some meaning has to be given and significance to be attached to the use of the word 'known' in the above definition. We think learned counsel is right in saying that this does not merely mean that the assessed should have a knowledge that some liability, present, future, disputed or contingent, may or may not arise at some date in the future. For, if that be so and if all such amounts were to be treated as provisions, then there would be no meaning to the foot-note that is to be attached to the balance-sheet to show separately:

'(1) Claims against the company not acknowledged as debts.

(2) Uncalled liability on shares partly paid.

(3) Arrears of fixed cumulative dividends.

(4) Estimated amount of contracts remaining to be executed on capital account and not provided for.

(5) Other money for which the company is contingently liable.'

and the further direction that:

'The amount of any guarantees given by the company on behalf of directors or other officers of the company shall be stated and, where practicable, the general nature and amount of each such contingent liability, if material, shall also be specified.'

27. Such an interpretation would also leave no amount whatever capable of being treated as a reserve, for, a company will set apart sums for future use only against the contingency of a liability that may arise in future. That apart, as the Kerala High Court has pointed out and as a Bench of this court had also occasion to mention in the Orissa Cement's case : [1980]124ITR251(Delhi) , there is good reason to restrict the scope of this expression by reference to the known financial position of the company, i.e., as it stands on a particular date and as a result of the financial working of the company during the earlier accounting year. In the Orissa Cement's case decided under the Super Profits Tax Act, we pointed out that the expression 'known' should be understood as referring to an existing liability and not to a future liability. But that was because the definition in the Companies Act and the terms of the Explanationn in the Act of 1964 were not available there. But even in the context of the 1964 Act, it appears to us that the whole object of the provision would be defeated if one were to consider even the setting apart of sums towards future liabilities, which may or may not arise at all as amounting to provisions. As pointed out by the Bombay and the Kerala High Courts it is necessary in the context to restrict the operation of this definition only to cases where there is a known liability, i.e., a liability referable to an outstanding transaction or an even that has taken place as a result of which it is definitely probable that a liability will be fastened on the company. For instance, the company may have drawn a large number of bills during the accounting year. But only a few of them might have been discounted by them with the bank or otherwise. The passage from Spicer and Pegler's Accountancy which we have extracted above would indicate that the provision that the company is expected to make would only be in respect of bills discounted though even there the entire amount of the bills discounted will not be set apart by the company. But where a bill has been discounted, there is an outstanding, a definitely probable liability on the part of the company in the event of some of the bills not being accepted when presented in due course. It is, thereforee, necessary that a provision should be made to meet this known liability, which cannot be accurately determined.

28. In the present case so far as the allocation for bonus is concerned, the allocation is not against any liability that has crystallised or accrued or is known to exist during the accounting year or as at the relevant date. The liability of the company to pay maximum bonus or minimum bonus to its employees would arise only in the event of the company incurring a loss or the company not having sufficient allocable surplus whether of that year alone or whether of that year and the earlier years out of which such bonus could be distributed. As at the relevant dates, in the present case, viz., April 1, 1965, and April 1, 1966, there is nothing to indicate that there was a definite probability of the company having to meet these liabilities which had not accrued during the accounting year but were likely to accrue in the immediate future. Unless there is on the relevant date some liability, present or future, in the contemplation of the director of the company, in respect of which the company would be called upon to shoulder the responsibility, the allocation cannot be said to be in the nature of a provision. We are, thereforee, in agreement with the conclusion of the Tribunal that there was no known liability as at the relevant date in respect of which the amounts could be said to have been set apart as provision.

29. For the above reasons, we answer the questions referred to us in the affirmative and in favor of the assessed. As the assessed has succeeded, it will be entitled to its costs of this reference: counsel's fee Rs. 500.


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