K.T. Desai, C.J.
1. This reference has been made under section 66(1) OF THE Indian Income-tax Act, 1922, at the instance of the Commissioner of Income-tax, Bombay North, Ahmedabad. The assessee in this case is the Viramgam Mills Co. Ltd. The relevant assessment year is 1952-53, the accounting year being the calendar year 1951. The assessee company is one in which at the relevant time the public were not substantially interested as envisaged under section 23A of the Income-tax Act. The balance-sheet of the company for the accounting year showed the paid up capital of the company as Rs. 6,98,000. On the Liabilities side of the balance-sheet there were the 'Buildings and Machinery Depreciation Fund' amounting to Rs. 6,24,948, the 'Reserve Fund' amounting to Rs. 2,20,000 and the 'Income-tax Fund in excess of requirement' amounting to Rs. 93,387, making in all Rs. 9,38,335. The sum of Rs. 6,24,948 under the heading 'Buildings and Machinery Depreciation Fund' had been carried forward from year to year in the balance-sheets of the company from the year 1946 onwards. In 1946 the assessee company had sold its buildings and machinery and realised a sum of Rs. 4,00,000 for its buildings and Rs. 21,99,038 for its machinery. It thus realised in all a sum of Rs. 25,99,038. The original cost of these buildings was Rs. 3,15,264, and that of the machinery was Rs. 10,44,491 making in all Rs. 13,59,755. The sum of Rs. 6,24,948 was made up of various amounts shown in the Buildings and Machinery Depreciation Fund year after year up to and inclusive of the calendar year 1945. In the balance-sheet as on December 31, 1945, the original cost of Rs. 13,59,755 was shown on the 'Assets side' and the provision of Rs. 6,24,948 was shown on the 'Liabilities side' under the head 'Buildings and Machinery Depreciation Fund'. For the assessment year 1952-53 the company's return showed an income of Rs. 81,860. It was assessed on an income of Rs. 81,935 and the tax thereon amounted to Rs. 35,591, leaving a balance of Rs. 46,344. The assessee company at its general meeting held on December 5, 1952, declared a dividend of Rs. 27,920, i.e., a little over 60 per cent. of Rs. 46,344. The Income-tax Officer, having regard to the paid up capital of the company and the total of the balances in the aforesaid three accounts amounting to Rs. 9,38,335, considered that the first proviso to section 23A of the Income-tax Act was applicable to the case. He considered the balance in the three accounts as reserves representing accumulation of past profits. He directed that the balance of Rs. 18,424 (Rs. 46,344 minus Rs. 27,920) also should be deemed to have been distributed among the shareholders of the company as on December 5, 1952. The Appellate Assistant Commissioner confirmed the action of the Income-tax Officer. There was a further appeal to the Income-tax Appellate Tribunal. It held that sum of Rs. 2,20,000 shown as a 'Reserve Fund' and the sum of Rs. 93,387 shown under the heading 'Income-tax Fund in excess of requirement' constituted reserves as contemplated under the afore-said proviso. As regards the sum of Rs. 6,24,948 under the heading 'Buildings and Machinery Depreciation Fund' the Income-tax Tribunal held that the same did not represent accumulations of past profits and that the same could not have been the subject-matter of an order under section 23A in the past. The Tribunal held that the Income-tax Officer was not justified in passing an order under the proviso to section 23A (1). A question of law having arisen, a statement of the case has been prepared and the matter has been referred to us under section 66(1).
2. The question of law that has arisen is the following :
'Whether, on the facts and circumstances of the case, the Depreciation Fund constitutes a reserve within the meaning of the first proviso to section 23A (1) ?'
3. It has been strenuously urged before us by the learned Advocate-General who appears for the Commissioner that the Buildings and Machinery Depreciation Fund constitutes a reserve within the meaning of the first proviso to section 23 A as it stood at the relevant time. That proviso runs as under :
'Provided that when the reserves representing accumulations of past profits which have not been the subject of an order under this sub-section exceed the paid up capital of the company, together with any loan capital which is the property of the shareholders, or the actual cost of the fixed assets of the company whichever of these is greater, this section shall apply as if instead of the words 'sixty per cent.' the words 'one-hundred per cent.' were substituted.'
4. In order that the proviso may apply it is necessary that the reserves shown in the balance-sheet must represent accumulations of past profits. It further contemplates that the past profits must have been such as could have been the subject of an order under sub-section (1) of section 23 A. An order under sub-section (1) of section 23A can be passed where the Income-tax Officer is satisfied that in respect of any previous year the profits and gains distributed as dividends by any company up to the end of the sixth month after its accounts for that previous year, as reduced by the amount of income-tax and super-tax payable by the company in respect thereof. In that event he is entitled, unless he is satisfied that, having regard to the losses incurred by the company in earlier years or to the smallness of the profit made, the payment of a dividend or a larger dividend than that declared would be unreasonable, to make with the previous approval of the Inspecting Assistant Commissioner an order in writing that the undistributed portion of the assessable income of the company of that previous year as computed for income-tax purposes and reduced by the amount of income-tax and super-tax payable by the company in respect thereof shall be deemed to have distributed as dividends amongst the shareholders as at the date of the general meeting aforesaid, and thereupon, the proportionate share thereof of each shareholder shall be included in the total income of such shareholder for the purpose of assessing his total income.
5. The learned Advocate-General argued that the sum of Rs. 6,24,948 represented accumulations of past profits. He urged that various amounts had been set apart under the head 'Buildings and Machinery Depreciation Fund' year after year and that the same must be regarded as having come out of past profits. In order to support his contention he invited our attention to a passage from a well-known treatise on Company Law by Palmer, twelfth edition, page 635. He referred to rule 4 of the rules for ascertaining 'divisible profits' mentioned at page 639 of that book. That rule runs as under :
'Loss or depreciation of assets.
(a) Loss or depreciation of fixed capital does not affect the divisible profits or render it necessary to make good the same out of the income; and
(b) in ascertaining divisible profits for a particular accounting period, loss or depreciation of circulating capital has to be deducted before the profits, if any, are arrived at.'
6. He also referred to rule 7 which relates to profits carried to reserve. The heading of that rule is 'profits carried to reserve remain profits unless capitalised.' It is then mentioned that 'profits applied in depreciating the book value of capital assets remain profits and may be written back as such if, in fact, the asset concerned has not depreciated in value.' The rule itself indicates that if the asset concerned has depreciated in value, the rule would not apply, at least, to the extent of the amount of such depreciation. In order to consider whether a particular reserve represents accumulation of profits or not, it is necessary to have a clear idea as to the meaning of the expression 'profits' as commercially understood. The concept of 'profits' has been very ably dealt with by Fletcher Moulton L.J. in a classical passage in In re Spanish Prospecting Co. Ltd. Says he :
''Profits' implies a comparison between the state of a business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets at the two dates... if the total assets of the business at the two dates be compared, the increase which they show at the later date as compared with the earlier date (due allowance of course being made for any capital introduced into or taken out of the business in the meanwhile) represents in strictness the profits of the Business during the period in question.'
7. This passage from the judgment of Fletcher Moulton L.J. has been quoted with approval at page 635 of Palmer's Company Law.
8. Mahajan J. as he then was, in the case of Commissioner of Income-tax v. Ahmedbhai Umarbhai & Co., has observed at page 502 as follows :
'Profits of a trade or business are what is gained by the business. The term implies a comparison between the state of business at two specific dates separated by an interval of an year and the fundamental meaning is the amount of gain made by the business during the year and can only be ascertained by a comparison of the assets of the business at the two dates, the increase shown at a later date compared to the earlier date represents the profits of the business.'
9. The observations of Fletcher Moulton L.J. in the case of In re Spanish Prospecting Co. Ltd. and the observations of Mahajan J. in Commissioner of Income-tax v. Ahmedbhai Umarbhai & Co. have been quoted with approval by Bhagwati J., in the case of E. D. Sassoon & Co. Ltd. v. Commissioner of Income-tax.
10. Reference in this connection may be made to a passage from paton's Accountants' Handbook, at page 747, under the heading 'Significance of Depreciation Reserve'. It is there stated as under :
'The depreciation reserve or allowance, to the extent that it measures a careful and reasonable estimate of accrued depreciation, should be interpreted not as a true reserve or appropriation of surplus but rather as a contra account - or valuation account - modifying the gross book value of the depreciable fixed assets. In particular cases the depreciation reserve may be in part surplus, as a result of setting up clearly excessive charges for depreciation, but this fact does not alter the nature of the typical reserve for accrued depreciation.
The use of the term 'reserve', which is well-nigh universal, is not altogether fortunate, particularly because of the standard use of this term in labelling genuine surplus appropriations and also because the layman, in particular, tends to think of the depreciation reserve, when so named, as a fund of cash or other liquid assets set aside for the purpose of replacing the depreciating property at the end of its service life.
The conventional depreciation reserve not only does not consist of an actual fund but can be said to represent or indicate a fund or property only in a very indirect way, if at all. The balance in the reserve or allowance for accrued depreciation represents just one thing - the estimated expiration is use of the depreciable property shown in other accounts at cost or other gross book value. This can be emphasized by calling attention to the fact that it is quite possible to account for depreciation by avoiding the use of the reserve account entirely through the use of a procedure by which the credits are lodged directly in the plant accounts.'
11. In Wixon's Accounts Handbook, fourth edition, it has been stated at page 17.49 in connection with 'Significance of Depreciation Allowance ' as under :
'Many years ago, Hatfield discussed the three common misconceptions regarding the allowance for depreciation :
1. The view that it represents a fund of money.
2. The view that it represents a reservation of profits.
3. The view that it constitutes inherently a provision for replacement.
Unfortunately these misconceptions still exist to-day and it is worth reviewing his discussion.
None of these views is sound (sic.) by pointing out that the allowance account represents nothing more than an estimated expiration of asset value, that depreciation goes on whether there are any profits or not and that the recognition of depreciation is a 'condition precedent to the ascertainment of profits', and that depreciation accounting should take the same form in the case of property which there is no intention or prospect of replacing as in any other case.
The depreciation allowance does not represent a specific fund of cash or other assets set aside to make good the depreciation; it rather expresses the estimated 'hold' in the assets subject to depreciation.'
12. The sum of Rs. 6,24,948 in the present case does not represent a specific fund or cash or other assets set aside to make good the depreciation. The buildings and machinery of the company throughout the years during which the sum of Rs. 6,24,948 has been built up have been shown at cost. The company could very well have, in its balance sheets, shown them, instead of at cost, at a written down value after deducting the amount of depreciation which those assets had undergone. The sum of Rs. 6,24,498 represents, to use the words of Wixon, 'the estimated expiration of asset value'. It does not represent accumulations of past profits. In fact the profits of the assessee company for the relevant years could only be truly ascertained after providing for the depreciation in the aforesaid assets of the company. An allowance for depreciation has to be made before the true profits are ascertained. The amount of depreciation does not represent something set apart out of the profits after the same are ascertained. In the present case the 'Buildings and Machinery Depreciation Fund' account represents the amounts deducted year after year by way of depreciation in order to arrive at the true profits of the company. If any part of the amounts so deducted did not represent the true amount of depreciation suffered by the buildings and machinery of the assessee company, then to the extent of such excess it could be said that the reserve had been built up out of the profits of the company. In the present case there is no evidence whatsoever to show that the sum of Rs. 6,24,948 or any part thereof was built up out of any profits. It is not shown that any provision that had been made by way of depreciation was in excess of the true requirement in that connection. Our attention has been called to a decision of the Supreme Court in Commissioner of Income-tax v. Bipinchandra Maganlal & Co. In that case it was observed that there was no definable relation between the assessable income and the profits of a business concern in a commercial sense, that the computation of income for purposes of assessment of income-tax was based on a variety of artificial rules and took into account several fictional receipts, deductions and allowances. That case turned upon the determination of the question whether a larger distribution of dividend by the company concerned would be unreasonable for the purpose of deciding whether a distribution order should be made under section 23 A of the Income-tax Act. In that case it was observed that the difference between the written down value of an asset and the price realized by the sale thereof was not really income, but was made taxable income for the purpose of computation of the assessable income by the fiction in the second proviso to section 10(2)(vii) of the Income-tax Act, read with section 2(6C), and that on that account it did not become commercial profit and was not liable to be taken into account in assessing whether in view of the smallness of the profits a larger dividend would be unreasonable. That Judgment does not in any way touch the question which we have to decide in the present case.
13. The above decision of the Supreme Court was given in appeal from a decision of the Bombay High Court reported in Bipinchandra Maganlal & Co. v. Commissioner of Income-tax. In the course of the judgment delivered by Chief Justice Chagla in that case he has observed at page 6 as under :
'The real position, it seems to us, is this that when an asset is depreciated from year to year and the depreciation is debited to the profit and loss account and comes out of the profits of a company, that amount constitutes a reserve created by setting apart a portion of the profits from year to year and not distributing those profits or not otherwise dealing with those profits.'
14. Some reliance has been placed by the learned Advocate-General on these observations. The observations are merely passing observations. If it is intended to suggest that depreciation in every case comes out of the profits of a company, with great respect, we are unable to agree with the same. Such observations would be contrary to the fundamental notion of commercial profits. Profits in the commercial sense can only be ascertained after taking into account depreciation. The correct amount representing depreciation does not come out of the profits of the company. As observed by Paton in his Accountants' Handbook, third edition, there is nothing at all imaginary about depreciation as a cost of business operation and at bottom it is just as much an out-of-pocket cost as any other. The depreciation charge is merely the periodic operating aspect of fixed asset costs and there is no the reserves in this case in any way or to any extent represent accumulations of past profits.
15. In the result the answer to the question is in the negative. We direct the Commissioner to pay to the assessee company the costs of the reference.
16. Question answered in the negative.