1. This is a case stated by the Income-tax Appellate Tribunal under the Companies (Profits) Surtax Act, 1964.
2. The facts as found by the Tribunal show that the assessee-company had set aside Rs. 1,02,995 from out of the profits from the year ended April 30, 1971, as and towards an account called 'Reserve for doubtful debts'. The assessee claimed that for the purpose of computing its capital as on May 1, 1971, this amount must be regarded as a reserve. The ITO rejected this claim. He held that the amount only represented 'a provision against anticipated loss or liability'. On appeal, the Tribunal held that the amount credited to this account was a reserve and must be taken as part of the company's capital, subject only to the officer verifying a matter of detail, namely, whether a sum of Rs. 14,482 can be included in that account.
3. The present reference before us is at the instance of the Department on the following questing of law :
'Whether, on the facts and in the circumstance of the case, the reserve for doubtful debts amounting to Rs. 1.02,995 (or such other amount as verified to be correct), should be included in working out the capital base for the purposes of surtax ?'
4. The question falls to be considered on an understanding and appreciation of the Second Schedule to the C.(P.) S.T. Act, 1964. Question of this nature have engaged the attention of this court and several other High Court for some time. Reported decisions are legion. Recently, however, the Supreme Court had occasion to consider this subject. They laid down the distinction, between a provision and a reserve, and the accountancy principles bearing on the point. They then referred to the provisions of the Companies Act which deal with the matter from the point of view of the balance-sheet requirement. Finally, they took up the construction of the relevant provision of the Second Schedule to the Surtax Act.
5. The decision of the Supreme Court is in Vazir Sultan Tobacco Co. Ltd. v. CIT : 132ITR559(SC) . According to the Supreme Court, a provision is meant to provide for any known charge or liability such as charge to meet depreciation of assets, renewal of assets or diminution in the value of the assets. In this sense, a provision is a charge against profits. A reserve, however, was an appropriation out of profits. Given the distinction between a provision and a reserve, Supreme Court laid down what the proper approach is to an enquiry under the Second Schedule to the Surtax Act. They suggested that we have first to ascertain whether a particular retention appropriation out of current profits falls under the classification 'provision'. If it is a provision, then, the amount will have to be excluded from the computation of capital. But even where the appropriation or retention is not a provision, it will still have to be decided whether the amount so retained or appropriated is a reserve or not. This must be done by reference to the nature and character of the amount appropriated, the intention and purpose of the account created, and other surrounding circumstances.
6. The Second Schedule to the Surtax Act refers to the development rebate reserve in r. 1(ii). Rule 1(iii) refers to 'other reserves'. The question is whether the reserve created in this case as a 'reserve for doubtful debts' falls under r. 1(iii) of the Second Schedule to the Surtax Act.
7. Debts are the assets of the creditor and figure as such in his balance-sheets. Just as every other asset has to constantly valued and revalued in balance-sheet after balance-sheet from the standpoint of rendering a 'true and fair' representation of the financial position of the business, so too a debt must be valued at every balance-sheet. A debt may be good, bad or doubtful at a given moment of time, when considered from the point of view of chances of recovery. If it is good it retains its position and value in every successive balance-sheet. If it is bad, it has to be written off in the year in which it becomes bad, and the write-off makes it vanish from the balance-sheet; the resultant position being effected by a diminution in the year's net profit, which is an item on the liabilities said of the balance-sheet, or by a swelling of the net loss, which is an item on the assets side of the balance-sheet. But where a debt is only doubtful of recovery, it cannot be treated in the accounts either as good or as bad. At the same time, there must be an indication in the balance-sheet that it is a doubtful debt, again, from the point of view of 'true and fair'. Hence it is that a provision has to be made on the liabilities side of the balance-sheet of an amount equivalent in value to the doubtful debts, while such debts would continue to retain their position on the assets side. Doubtful debts are provided for in this manner by charging the profit and loss account. It is not done by making an appropriation, after the profit is struck in the profit and loss account.
8. It is clear, therefore, that even where the balance-sheet nominally speaks of a 'reserve for doubtful debts' it is really a provision. But the provision must be a real provision in the sense that the amount provided for is the end result of an evaluation of the doubtful debts and is equivalents to the sum total of the doubtful items alone. Where a lump sum or an ad hoc amount is charged to profit and loss towards doubtful debts, willy-nilly, and without regard for the recovery aspects, then it cannot be a provision; it is only a reserve. So too where there is an over-provision, as when good debts also go into the reckoning. In such a case, to the extent of the over-provision, it is a pucca reserve, and not a provision for doubtful debts.
9. In this case, Rs. 1,02,995 is shown as 'Reserve for doubtful debts' on the liabilities side of the assessee's balance-sheet as on April 30, 1971, thus :
Reserve for Doubtful Debts Rs.As per last balance-sheet 48,197.38Add: Transfer from profit & loss account 54,797.94- ----------- 1,02,995.32- -----------
10. It will be noticed that the figures are not round figures. It appears from the record that the figure Rs. 48,197.38 which is carried forward from the balance-sheet as on April 30, 1970, itself consisted of two amounts : Rs. 33,714.81 transferred from the P&L; a/c of the year ended April 30, 1970, and Rs. 14,482.57 carried over from the earlier balance-sheet as at April 30, 1969.
11. The normal conclusion from the above balance-sheets must, therefore, be that it is a misnomer to call the account relating to doubtful debts as a 'reserve' and it is legitimate to regard it only as a provision. And, as a provision, there can be no doubt that it has to be excluded from the computation of the capital of the assessee under the Second Schedule to the Surtax Act. This is what the ITO held. We are also of the same view, because it fits in with the legal position now laid down by the Supreme Court in Vazir Sultan's case : 132ITR559(SC) .
12. The assessee's case, however, is that it is a reserve. The justification for its having to be treated as a reserve, according to the assessee, is provided by an important feature of the assessee's practice. It is said that every year bad debts are written off, not by debit to this so-called reserve, but by debit to the P&L; a/c. Year after, it is said, this 'reserve' is being only augmented, is not 'raided' at all write-off of bad debts. In this very year ended April 30, 1972, we gather that the assessee wrote off something like Rs. 1,42,008.69, but that was also by debit to the P&L; a/c. and not by debit to this particular 'reserve'. This feature, it is urged, really makes the 'reserve for bad debts' as good as its name. The suggestion is that the situation, in effect, is the same as if there is an ad hoc provision or an over-provision.
13. We must reject this contention as unsound. The argument overlooks the intention with which or the purpose for which the account is being built up over the years. The real aim of the reserve for 'doubtful debts' as its name indicates, is to make a provision for doubtful debts so that it may have a cushioning-off effect when the time comes for writing off such of those doubtful debts which turn out to be bad. The way in which and the precise amounts with which this account has been built over the years furnish evidence of a meticulous evaluation of the debts which the assessee must have gone through to find out the chances of recovery and to make appropriate provision only for those debts which are doubtful in that regard. Judging this account both by its character and by its aim, therefore, there is nothing to indicate that it was not a provision. What the assessee's contention amounts to is, 'forget the aim of the account, forget by the character of the account; only see how the account was dealt with by the assessee in practice'.
14. We cannot accept this approach as proper one. The Supreme Court no doubt have said somewhere in their judgment in the Vazir Sultan's case : 132ITR559(SC) , that we will have to examine not only the purpose and the character of the account but also the surrounding circumstances to see if a reserve is a reserve and not a mere provision. We do not, however, think that the way in which the assessee treated this account can be considered at all as relevant to the discussion. In our view, the fact that an assessee, having made what is truly a provision in the balance-sheet, proceeds to treat it with scant respect, cannot convert a provision into a reserve. A reserve and a provision are what they are because of how they are created and for what purpose they are created. They do not lose their respective character and assume a different one, for no other reason than that they were practically ignored by their creator subsequently. More honoured in the breach than in the observance it may be, but that cannot alter the character or the provision.
15. There is yet another consideration for holding that Rs. 1,02,995 is only a provision and not a reserve. Before the Tribunal the assessee had contended that the account was really a reserve and it was meant for the contingency of huge bad debts arising which are not capable of being met out of the profits. So, till so long the reserve stood intact, it was urged, it must be accepted as a reserve. The Tribunal gobbled up this argument. The Tribunal's reasons are to be found in an earlier order relating to this very assessee. The Tribunal adopted those reasons in the order now under reference. The reasons are reproduced below verbatim :
'Here also it is clear that though the measure of the reserve is in terms of the amount considered as bad and doubtful debt, no specific tie-up of this item is noticed. On the other hand, this reserve is built up only for future contingency in case large bad debts had occurred and had to be written off. In other words, this is almost like dividend equalization reserve which is kept up only for future contingency when profits may not be enough to distribute to the shareholders. Only when necessity arises to draw from the reserve it is stated to be drawn from the reserve. In other words this reserve will be continuing as reserve unless such a contingency as large bad debts arising and not capable of meeting out of the profits of the company had occurred.'
16. There is more than on flaw in this passage. The Tribunal have them selves pointed out that 'the measure of the reserve' is 'in terms of the amount considered as bad and doubtful debts'. If so, we fail to see how the Tribunal could say at the same breath, that there is no specific tie-up with doubtful debts, or that the reserve is built up for some unforeseen 'future contingency' in the case of 'large bad debts'. There is nothing to show how many of the debts are big and how many are small in the provision made, so far, Rs. 1,02,995. Besides, where is the unknown 'future contingency' when the Tribunal themselves say' it is clear' that the measure of the reserve is in terms of the amount considered as bad and doubtful debts. The Tribunal have also sought to draw a parallel from the dividend equalization account, without saying what are the characteristics of that account which make it a revenue account. Lastly, it is said that the amount of Rs. 1,02,995 is intended to be continued as a reserve, unless a contingency of a big bad debt arises. Which was not capable of being met out of the assessee's profits. This claim of the assessee is belied by the fact that the amount of debts written off in the P&L; a/c. in this year is quite big, namely, Rs. 1,42,008.69, which is bigger even than the amount provided for in the balance-sheet namely, Rs. 1,02,995.32. In any case, even accepting that the so-called reserve of Rs. 1,02,995.32 was for the contingency of a big bad debt, still that would not make it anything other than a provision : unless the suggestion is that the assessee can create a reserve even before any debts come into being, which would be quite odd.
17. We thus reject the Tribunal's conclusion as based on a misdirection in law, or rather, on a multiplicity of misdirections.
18. Learned counsel for the assessee referred to a few decisions of the High Courts. We do not think we need examine any of those decisions considering that a comprehensive enunciation of the law on the subject has been provided by the decision of the Supreme Court in Vazir Sultan's case : 132ITR559(SC) , which we have earlier referred to. A discussion of the earlier case law would, in our opinion, only tend to obfuscate the legal position.
19. For the reasons stated above, we answer the question in the negative and against the assessee. The department will have its costs. Counsel fee Rs. 500.