1. 1. The question arising in this reference is whether it is permissible to the Income-tax department to deduct from the taxation reserve account shown on the credit side of the balance-sheet, the amount of taxes paid from the other available funds of the assessee-company which computing its capital under the Business Profits Tax Act, XXI of 1947.
2. That Act came into force on the 11th of April, 1947, having taken the place of the Excess Profits Tax Act which was repealed on March 30, 1946. Section 4 of the Act, which is the charging section, provides that subject to the provisions of the Act, there shall, in respect of any business to which the Act applies, be charged, levied and paid on the amount of the taxable profits during any chargeable accounting period, a tax (business profits tax) which shall, in respect of any chargeable account period ending on or before the 31st day of March, 1947, be equal to sixteen and two-thirds per cent. of the taxable profits, and in respect of any chargeable accounting period beginning after that date, be equal to such percentage of the taxable profits as may be fixed by the annual Finance Act. By Finance Acts of 1948 and of 1949, the amount of taxable profits was reduced from sixteen and two-thirds per cent. of the taxable profits to ten per cent. Section 2(17) defines 'taxable profits' as meaning the amount by which the profits during a chargeable accounting period exceed the abatement in respect of that period. 'Abatement' has been defined in clause (1) of section 2 and, so far as is relevant for the purposes of this reference, means, in respect of any chargeable accounting period, ending on or before the 31st day of March, 1947, a sum which bears to a sum equal to - (a) in the case of a company, not being a company deemed for the purposes of section 9 to be a firm, six per cent. of the capital of the company on the first day of the said period computed in accordance with Schedule II, or one lakh of rupees, whichever is greater. The business profits tax was therefore on the percentage allowed under the relevant Finance Act corresponding to the chargeable accounting period on taxable profits less the abatement computed in accordance with Schedule II of the Act. The accounting period, according to clause (2) of section 2, means a period in relation to any business which is or has been determined as the previous year for that business for the purposes of the Income-tax Act. 'Chargeable accounting period', as defined by clause (4) of section 2, means any account in period falling wholly within the term beginning on the first day of April 1946, and ending on the 31st day of March, 1949, and where any accounting period falls partly within and partly without the said term, such part of that accounting period as falls within the said term. The proviso to that clause provides that where an accounting period falls partly before, and partly after, the end of March, 1947, so much of that accounting period as falls before, and so much of that accounting period as falls after, the end of March, 1947, shall be deemed each to be a separate chargeable accounting period. So far as the present reference is concerned, the chargeable accounting periods are from January 1, 1948, to December 31, 1948, and January 1, 1949, to March 31, 1949.
3. For the purpose of arriving at the figure of abatement, the method of computing the capital and taxable profits is provided for in Schedule II, rules 1 and 2, to the Act. Rule 1 provides that for the purposes of ascertaining abatement under this Act in respect of any chargeable accounting period, the capital of a company shall be computed in accordance with the rule following thereto. Rule 2(1) then provides that where the company is one to which rule 3 of Schedule I applies, its capital shall be 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 Income-tax Act, diminished by the costs to it of its investments or other property, the income from which is not includible in the profits, so far as that costs exceeds any debt for money borrowed by it. Sub-rule (2) of rule 2 provides that in all other cases the capital shall be the sum ascertained in accordance with sub-rule (1) diminished by the cost to the company of its investments so far as that cost exceeds any debt for money borrowed by it.
4. The assessee-company used to maintain what it called 'income-tax, super-tax, excess profits tax and deposit fund', and also the 'taxation reserve account', which admittedly was build out of the profit appropriations from time to time. The company used to pay taxes under an account called the 'taxes paid account' in which the amounts paid during the current year by way of advance, provisional and other taxes during the current year from the company's funds were debited. The system of accounting followed by the company was that after the assessments were finalised and the amounts of taxes were crystallised, the amounts of such taxes were transferred from the 'taxes paid account' to the 'taxation reserve account' and debited in that account, thus reducing the balance in that account and a corresponding credit entry used to be made in the second account, i.e., the 'taxes paid account' and that account was the enclosed so far as that assessment so finalised was concerned. If on such finalisation of assessment, any refund was payable to the assessee-company in respect of any assessment year, the amount of such refund used to be credited to the 'taxation reserve account', that account, after the finalisation of the assessment, being the only available account. If the assessee-company at any time felt that there was any excess amount in the 'taxation reserve account', such excess used to be transferred to the general reserve fund. In the year 1947, a sum of rupees twelve lakhs was in fact thus transferred from the 'taxation reserve account' to the 'general reserve fund.'
5. The position on the 31st December, 1947, and the 31st of December, 1948, in regard to these two accounts was as follow : On the 31st of December, 1947, there was to the credit of the 'taxation reserve account' a sum of Rs. 11,65,523-10-4 and on the 31st of December, 1948, there was to the credit of that account a sum of Rs. 6,77,917. So far as the second account, that is to say, the 'taxes paid account', was concerned, it showed on the 31st of December, 1947, a sum of Rs. 10,60,614 and on the 31st of December, 1948, a sum of Rs. 9,35,774 as having been paid towards the taxes during the two current years. Out of the amount of Rs. 10,60,614 the assessee-company had paid on the 30th of September, 1947, a sum of Rs. 1,19,470 and a further sum of Rs. 1,19,470 on the 31st of December, 1947, as advance taxes totalling to Rs. 2,38,940. Out of the sum of Rs. 9,35,774 which was shown in the 'taxes paid account' on the 31st of December, 1948, the assessee-company had paid during the calendar year 1948 a total amount of Rs. 5,18,156 as and by way of advance taxes (income-tax and corporation tax) under section 18A of the Income-tax Act.
6. The assessee-company claimed that it was entitled to treat these two amounts, namely, Rs. 11,65,523-10-4 and Rs. 6,77,917 standing to the credit of the 'taxation reserve account' as capital for the purposes of computation under rule 2 of Schedule II to the Act. The Income-tax Officer, however, while completing the assessments for the two chargeable accounting periods, set off the sums of Rs. 10,60,614 and Rs. 9,35,774 shown in the taxes paid account' against the balances in the 'taxation reserve account' at the beginning of each of the chargeable accounting periods, and included only the net figure, i.e., positive in the case of the first chargeable accounting period and negative in the case of the second chargeable accounting period, in the capital computation for the purposes of abatement. Aggrieved by this decision, the assessee-company filed an appeal before the Appellate Assistant Commissioner who dismissed the appeal in respect of the chargeable accounting period January 1, 1948, to December 31, 1948, by observing as follow :
'Now to my mind it is necessary to determine whether the taxation reserve of Rs. 11,65,524 is a real reserve set apart for meeting some future liability. This is a specified reserve and to the extent to which the same specific liability has already been met, the effect will be that the reserve will be depleted to the extent of the liability already discharged. It is necessary to took to the substance of the matter and not to the form in which the assessee chooses to make entries in the books of accounts. The assessee could have reduced the tad payments on the assets side from the taxation reserve and shown only a net reserve. In any case it is only the net figure which can really be termed as a reserve set apart for meeting any future liability. Thus on January 1, 1948 the taxation reserve was in substance not the gross figure of Rs. 11,65,524 but the net figure of Rs. 1,04,910 after reducing therefrom the taxes that have already been paid.'
7. For the next chargeable accounting period, i.e., January 1, 1949 to March 31, 1949, he directed that the negative must be ignored and thereby increased the capital by Rs. 2,57,256.
8. The assessee-company filed appeals against these orders before the Income-tax Appellate Tribunal and, inter alia, contended (1) that it was an error to deduct the amounts of advance and other taxes paid from the 'taxation reserve fund', (2) that in the alternative, even if the department was right in so deducting, the amount of advance taxes, namely, Rs. 2,38,940 for the assessment year 1948-49, in any event, should have been excluded from Rs. 10,60,614 which were deducted from the 'taxation reserve account'. So far as the chargeable accounting period January 1, 1949, to March 31, 1949, was concerned, it was contended that the amount of Rs. 6,77,918, which stood to the credit of the 'taxation reserve account' should have been held as a reserve and, in the alternative, it was further contended that the advance tax in any event in respect of the year 1948 should have been excluded from the amount of Rs. 9,38,174 inasmuch as the advance tax related to the profits of the year 1948 and not to be taken into account for capital computation. The Tribunal accepted the contention of the assessee company, observing that the taxation reserve had been build up out of the past profit appropriations and that the reserve balances were not identified with the actual liability of taxation as on the respective dates and therefore, it would not be incorrect to say that they too were, in the manner in which they had been operated in this case, nothing more than general reserves. The Tribunal observed that when taxes are paid, they are either debited to this reserve or another suspense account shown independently on the assets side of the balance-sheet. Their eventual destination can very well be either the taxation reserve account or the profit and loss account. If it is debited to the taxation reserve, the reserve would get depleted and it is only such depleted balances that would get into the capital computation by the aforesaid rule of thumb method. If it is debited to the profit and loss account this account will be either depleted or go into debit to be shown on the assets side of the balance-sheet. In either case, such a balance, either credit or debit, would be outside the scope of capital computation.
9. The learned Advocate-General, on behalf of the Commissioner of Income-tax, has disputed the correctness of these conclusions of the Tribunal and submitted (1) that the reserves within the meaning of rule 2, Schedule II of the Act, must in substance and reality be reserves and not merely in name, (2) then in the instant case, the system of accounting adopted by the company showed that the taxes were paid first from the unappropriated available funds and debited as advances, that they were transferred at some subsequent date to the reserve account and debited in that account after making a corresponding credit entry in the 'taxes paid account', thus showing that the payments of taxes were made in effect and substance from the reserve account, (3) that the fact that the refund of taxes, though small amounts, were credited to the 'taxation reserve account', indicated that that account was the one to which were referable all payments of taxes and, lastly, (4) that if such as account was treated as a reserve account, it would be possible for as assessee to have his capital artificially inflated by not paying taxes from the funds specially created for that purpose and paying them from other available funds. The learned Advocate-General drew our attention to the decision in Commissioner of Income-tax v. Century Spinning and ., where the Supreme Court has given the meaning of the expression 'reserves'. In that case, for the year ending 31st December, 1945, the profit of the assessee-company, whose accounting year was the calendar year, was a certain sum according to the profit and loss account. After making provision for depreciation and taxation, the balance of rupees five lakhs and odd was carried to the balance-sheet. This sum was not allowed in computing the profits of the assessee for the purposes of income-tax. In February, 1946, the directors recommended that out of that amount a sum of rupees four lakhs and odd should be distributed as dividend and the balance was to be carried forward to the next year's account. This recommendation was accepted by the shareholders in their meeting held on April 3, 1946, and the amount was shortly afterwards distributed as dividend. In computing the capital of the assessee-company on 1st April, 1946, under the Business Profits Tax Act, the assessee-company claimed that the aforesaid sum of rupees five lakhs and odd and the profit earned by it during the period 1st January, 1946, to 1st April, 1946, should be treated as reserves for the purpose of rule 2(1) of Schedule II. The Supreme Court held that the amount of rupees five lakhs and odd as also the profit earned by the assessee-company from 1st January, 1946, to 1st April, 1946, did not constitute reserve within the meaning of rule 2(1) of Schedule II. At page 503 of the report the Supreme Court observed that while considering whether a particular funds is a reserve or not, two essential characteristics must be present before the assessee can avail himself of the benefit of the rule, namely, that the amount should not have been allowed in computing the profits of the company for the purposes of the Income-tax Act and that it should be a reserve as contemplated by the rule. After examining the dictionary earning of the word 'reserve' in Webster's and Oxford Dictionaries, the Supreme Court stated that the true nature and character of the disputed sum must be determined with reference to the substance of the matter and when this was borne in mind, it followed that on the 1st of April, 1946, which was the crucial date, the sum of rupees five lakhs and odd could not be called a 'reserve' for nobody possessed of the requisite authority had indicated on that date the manner of its disposal or destination. On the other hand, on the 28th February, 1946, the directors clearly reserve. Nor did the company in its meeting on the 3rd April, 1946, decide that it was a reserve. It remained on the 1st of April, as a mass of undistributed profits which were available for distribution and not earmarked as 'reserve'. On the 1st January, 1946, the amount was simply brought from the profit and loss account to the next year and nobody with any authority on that date made or declared a reserve. The reserve maybe indication to show whether it was a reserve either of the one or the other kind. The fact that it constituted a mass of undistributed profits on the 1st January, 1946, cannot automatically make it a reserve. Some guidance can also be had in regard to the connotation of the expression 'reserve' from the decision in Indian Steel and Wire Products Ltd. v. Commissioner of Income-tax, where it was held that if the surplus amount is simply carried forward without the persons in requisite authority allocating it to any particular purpose as a reserve, it does not acquire the character of a reserve for the purpose of capital computation under the Business Profit Tax Act. In that case, the balance-sheet of the assessee-company for the year ending 31st March, 1946, showed a certain sum as unappropriated balance. This sum was made up of two smaller sums, namely, (1) an amount which had been carried forward out of the balance as at the last date of the previous year, i.e., as on 31st March, 1945, and (2) an amount which was the balance of the profit for the year 1945 -46. The assessee-company claimed that it was entitled to have the entire amount treated as 'reserve' for the purposes of computation of its capital for the chargeable accounting period ending 31st March, 1947. It was held that as the company had not indicated the manner of disposal or the destination of the balance of the profits of the previous year 1944-45 as well as the profits of the year 1945-46, neither amount could be considered to be a 'reserve' for purposes of rule 2(1) of Schedule II to the Business Profits Tax Act. The principle following from these two decisions, therefore, is that a fund lying with the assessee-company on the relevant date does not become, and cannot be treated as, a reserve unless someone possessed of the requisite authority has decided the manner of its disposal and has also decided to treat it as a reserve.
10. As we have already observed, the assessee-company maintained two accounts, one called the 'taxation reserve account' and the other called the 'taxes paid account'. It is not in dispute that advance taxes used to be paid from the second account and debited in that account and these amounts were not transferred to the first account until the assessments, in respect of which they were paid, were finalised. The amounts of advance and other taxes paid out of the second account were obviously paid from the funds otherwise available to the company, in the words of the Supreme Court, from funds which were a mass of undistributed profits, and not from funds earmarked as reserve funds. To deduct this amount paid from such undistributed funds in the curse of the computation of capital from the amounts standing to the credit of the 'taxation reserve account'. would in fact amount to treating such amounts as reserves though the payments were made, not from the fund earmarked as such reserves, but from funds which were undistributed profits.
11. Now it cannot be disputed, and in fact the learned Advocate-General conceded, that an assessee is entitled, unless there is anything contrary in the taxing statute, to maintain his own system of accounting. The system of accounting adopted by the assessee-company in the instant case was to treat all payments of advance and other taxes during the relevant assessment years, as advances until the assessments were finalised. The system so adopted by the assessee-company has, to a certain extent, justification inasmuch as an assessee is not likely to anticipate with full certainly as to what precise amount he would be assessed finally, as there are likely to be some items in his return of a debatable character. Until, therefore, an assessment is finalised, it would be correct on his part to treat the amounts paid by way of provision and advance takes as advances and not to debit them in 'the reserve fund account' created by his for tax purposes. This conclusion is to a certain extent supported by a passage in Spicer and Pegler's Practical Auditing, Indian Edition by S. V. Ghatalia, 1962 edition at page 384, where it is stated that a company under the Income-tax Act would meet its tax liability (i) by advance payment of tax (ii) by payment of tax on provision assessment under section 141, (iii) by deduction of tax at source, and (iv) on the completion of the regular assessments. Until the assessment was completed, the tax paid by the company except on regular assessment would stand debited to the respective accounts, as the case my be, and the said accounts should appear in the balance-sheet on the assets side. On completion of the assessment, the amount already paid by the company would be set off against the provision for tax. If on final assessment the company is entitled to a refund, the amount of refund would be shown on the assets side of the balance-sheet. There is thus authority for the proposition that payments made for taxes, until the assessment is finalised, must be shown as advances and made from the common fund and such payments, therefore, are not debitable to the reserve. If the submission of the learned Advocate-General were to be accepted, it would really amount to adding one more condition to the conditions in rule 2 of the Schedule II of the Act, namely, that if a reserve amount is not used for the purpose of payment of taxes but the taxes are paid from other funds, the payment should be deemed to have been made from the reserve fund or the reserve amount and, to that extent, they should be deducted from such fund or account. In our view, there is no warrant or justification for the addition of such a condition to the conditions laid down in rule 2, Schedule II. The learned Advocate-General, however, relied upon the decision of the Calcutta High Court in Debaprasanna Mukherji v. Commissioner of Income-tax in which the High Court held that where payments are received by an assessee as payments of interest, the nature of such payments could not thereafter be changed by merely treating them as being payments into a suspense account, and that the fact that the assessee claimed that as the mortgage litigation in that case had not ended, the amounts were not assessable, was wholly immaterial. The assessee there was carrying on money-lending business and had purchased the interest of a mortgage in 1922, in execution of a decree obtained against him by the assessee's father. In 1922, he instituted a suit or the mortgage. Prior to 1930, the assessee received several sums as interest which were not included by him in his returns of income on the ground that they were not yet taxable as the litigation had not concluded. The income-tax authorities were also of the opinion that the assessee had treated all payments as being made into a suspense account. In 1943, the income-tax authorities sought to reassess under section 34 of the Income-tax Act the payments as income of the year 1939-40 on the ground that this income was not received or did not become taxable until the mortgage transaction had been completed by the acceptance of a property by the assessee in 1939 in full discharge of all outstanding obligations. The High Court there observed the since the assessee had accepted the payments as payment of interest, the mere fact of his treating them as being payments in suspense account or his claim that as the mortgage litigation had not ended, the amounts were not assessable, did not prevent those payments of interest being taxed. Relying upon this decision, the learned Advocate-General contended that merely because taxes were paid from the 'taxes paid account' and these amounts were not transferred to 'the taxation reserve account' until the assessments were finalised, did not make any material different, and submitted that the taxes paid from the other funds must, therefore, be treated as having been paid from out of the reserve fund specially created by the assessee-company for that purpose. In our view, such a conclusion is not deducible from the Calcutta decision. In the instant case, as we have already observed, the assessee was entitled to select his own system of account and if he chose to pay the taxes during any current year from out of unreserved and undemarcated funds and did not look to the reserve for the payment of such taxes, in particular advance taxes, there is nothing either in the provisions of the Act of in rule 2 to justify the income-tax department to treat such payment as having been made from the reserve fund and to proceed to deduct such amount from out of the reserve fund for the purposes of the computation of capital under rule 2(1) of Schedule II to the Act. As observed in Indian Steel and Wire Products Ltd. v. Commissioner of Income-tax, a reserve is, by its very nature, a fund which is created and maintained for the purpose of being drawn in future, and nothing can be reserved unless it has been reserved or laid by or stored for use or application in a future contigency which is anticipated as certain or likely. Therefore, payments which are made in discharge of a present liability in the course of the year to which the balance-sheet and profit and loss account relate cannot be said to be made by way of creating a reserve. They are clearly of the nature of expenditure although it may not be expenditure in the income-tax sense allowable in an assessment. A reserve is created only out of the whole or a part of the surplus profits as they are found to be in the hands of the company at the end of the year. Obviously, advance payments of tax made under section 18A of the Income-tax Act cannot be treated as part of the reserves for the purposes of the Business Profits Tax Act unless credit in respect of them is actually given in the regular assessment. Advance payments of tax made under section 18A are payments on account, made under the compulsion of a statute, towards the discharge of an instant liability for liquidating a charge, the precise measure of which is to be determined at a later date. In respect of the payments made by an assessee as and by way of such advance payment under section 18A of the Income-tax Act, the disposing power of such an assessee over the moneys paid as advance taxes is completely and irretrievably lost and, therefore, it would not be possibly to say that moneys are still lying as part of his reserve. It is clear, therefore, that payments made by the assessee-company towards its liability of advance payments under section 18A of the Income-tax Act, cannot be said that the assessee-company, at the time when such payments were made, looked to the 'taxation reserve account' for its payments. In our view, the 'taxation reserve account' in the instant case was constituted to meet the liability of taxation on assessments when finalised. This is borne out by the system of accounting consistently followed by the assessee-company for a number of years and the finding of the Tribunal itself is to the effect that the advance income-tax instalments were paid and debited to the 'advance tax paid account' pending transfer to the 'taxation reserve account' on completion of the respective assessments. This system, to our mind, is in consonance with the principles of accountancy. The reserve account is not for advance payments under section 18A of the Income-tax Act or other provisional taxes, but it is a reserve only for taxes crystallized after final assessment. Both the accounts are separated and independent of each other. The assessee-company would look to the 'taxes paid account' for the purposes of payments of advance taxes and look to the other account, namely, the 'taxation reserve account' for the payments of taxes after the final assessment. Clearly, therefore, no question would arise of deducting from the 'taxation reserve account' the amount of advance taxes and other taxes paid from out of the other account. Therefore, the Tribunal was right in setting aside the conclusion of the Income-tax Officer and the Appellate Assistant Commissioner and in holding that the amounts of taxes paid were not deductible from the income-tax and super-tax fund account or, as has been sometimes called, the 'taxation reserve account'. In this view, the second question referred to us would not really arise. But in case we are not correct on the first question, the position as regards advance taxes is clear for they in any event cannot be deducted from the reserve account as from their very nature, in spite of the instant statutory liability, payments made in respect finalisation of the respective assessments. So far as the third question is concerned, the learned Advocate-General has not pressed that question and, therefore, it does not become necessary for us to answer it.
12. Question Nos. 1 and 2 which have been framed by the Tribunal, in our view, are not happily framed and we feel that the proper way to frame those questions is the one which has been suggested in paragraph 19 of the statement of the case. We, therefore, reframe questions Nos. 1 and 2 as follow :
'1. Whether for the purposes of computing the capital of the assessee-company under the Business Profits Tax Act, taxation reserve (shown on the credit side of the balance-sheet) should be reduced by the amount of tax paid (shown on the debit side of the balance-sheet
2. If the answer is in the affirmative, whether for the purpose of computing the capital of the assessee-company under the Business Profits Tax Act, the amounts of Rs. 2,38,940 and Rs. 5,18,156 being the advance income-tax paid in respect of profits of calendar years 1947 and 1948, should in any event not be deducted from the taxation reserve fun ?'
13. Our answer to the questions referred to us are as follow :
Question No. 1. - in the negative.
Question No. 2. - in the affirmative.
Question No. 3. - not pressed and, therefore, does not require to be answered.
14. The Commissioner will pay to the assessee-company the costs of this reference.
15. No order on the application.