1. The following common question has been referred to this court in T. C. Nos. 320 and 321 of 1978 by the Income-tax Appellate Tribunal at the instance of the Revenue:
'Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that the amounts credited in the asset replacement reserve, debenture redemption fund and staff retirement gratuity reserve should be taken into account for the purpose of computation of capital for the purposes of surtax?'
2. In T. C. Nos. 375 of 1978, the Income-tax Appellate Tribunal has referred to this court the following question again at the instance of the Revenue:
'Whether, on the fact's and in the circumstances of the case, the amounts credited in the assets replacement reserve and debenture redemption fund of Rs. 42,000 and Rs. 21,071, respectively, should be tax into account for the purpose of computing the capital for the purpose of surtax?'
3. The assessee-company, in the course of the assessment for the assessment years 1971-72 and 1972-73, claimed before the Income-tax Officer that the following three reserves should be included in the computation of capital for the purpose of surtax:
(1) Asset replacement reserve 1,50,000 1,50,000
(2) Debenture redemption fund 1,40,000 1,80,000
(3) Reserve for staff retirement gratuity 1,70,000 1,90,000
4. The Income-tax Officer did not accept the assessee's claim for the reasons set out in his order. On appeal by the assessee, the Appellate Assistant Commissioner accepted the assessee's claim in respect of the said three items. Then, the Revenue took the matter in appeal to the Income-tax Appellate Tribunal. The Tribunal, following the decision of the Allahabad High court in CIT v. British India Corporation (P.) Ltd. : 92ITR38(All) , upheld the claim of the assessee and dismissed the appeal filed by the Revenue.
5. For the assessment year 1973-74, the assessee made a claim for inclusion of the following three items in the computation of capital for the purpose of surtax:
(1) Asset replacement reserve 4,20,000
(2) Debenture redemption reserve 2,10,171
(3) Staff retirement gratuity reserve 2,10,000
6. That was rejected by the Income-tax Officer. On appeal, the Appellate Assistant commissioner upheld the claim of the assessee. On appeal by the Revenue, the Tribunal held that the assessee's claim has been rightly upheld by the Appellate Assistant Commissioner. However, a reference was sought by the Revenue in respect of the above three items, viz., asset replacement reserve, debenture reserve fund and staff retirement gratuity reserve. The question now for consideration before this court is whether any or all of the items, viz., asset replacement reserve, debenture reserve and staff retirement gratuity reserve could be included in the computation of capital for the purpose of surtax for the assessment years in question.
7. So far as the asset replacement reserve is concerned, the contention of the Revenue is that it is only a provision and not a reserve, that the provision has arisen only as a result of the revaluation of the assets and, therefore, should be taken as a revaluation on depreciation reserve and as such it should be taken as a provision. The Revenue puts forward an alternative contention that, the even if it is taken as a reserve, in view of the Explanation 1 to rule 2 of the Second Schedule to the Companies (profits) Surtax Act, 1964, a reserve arising out of revaluation of the assets cannot be included in the capital. According to the said Explanation 1, any reserve brought into existency by creating or increasing by revaluation or otherwise, any book asset is not capital for computing the capital of a company of the purpose of this Act. The Explanation specifically exclude any reserve which was brought into existency by revaluation of the assets from capital. According to the Revenue, in view of the said Explanation et out above, the asset replacement reserve which was admittedly been created by revaluation of the assets cannot be included in the computation of the capital. That this reserve is on which come into existence as result of revaluation of the assets is clear from the order of the Income-tax Officer for the assessment year 1971-72, where he observes:
'it has been clearly brought out in the directors' reports for the year ended June 30, 1969 as under: 'Consequent upon the revaluation of the fixed assets during 1967-68, it has become a necessary to create an 'assets a replacement reserve' to cover depreciation on the enhanced value of the assets, and, for this purpose, only an amount of Rs. 1,40,000 has been transferred from the profits of the year.
It is clear from the above that due to inflation or the other causes well know to the directors, the replacement of the assets will cost more in future and a specific reserve is created of this purpose. It is, therefore, apparent that this is only a specific provisions and cannot be termed as a free reserve. This will also not qualify for capital computation.'
8. The contention of the assessee, on the other hand, is that Explanation 1 to rule 2 of the Second Schedule will not, in terms, apply as the reserve had been created to cover depreciation on the enhanced value of the assets and, therefore, the reserve a cannot be said to have been created on revaluation of the assets as contemplated by the said Explanation. However, we are of the view that the said Explanation will apply to the amounts set apart as asset replacement reserve, for the necessity to created a reserve arose only as a result to the revaluation of the fixed assets. Therefore, its is unnecessary to go into the question whether this reserve is a provisions or not, as Explanation 1 is a sufficient answer to the claim made by the assessee in this case for inclusion in the a capital.
9. Both the Appellate Assistant Commissioner and the Tribunal have based their decisions on the decision of the Allahabad High Court in CIT v. British India Corporation (P.) Ltd. : 92ITR38(All) . In that case, the court had observed that when an amount is set apart for a further liability, it is called a reserve an when it is set apart to meet an existing liability, it is called a provision and, therefore, capital reserve, stocks and stores reserve, bad and doubtful debts reserve, obsolescence reserve, loans and insurance reserve and investment reserve have to be treated as reserves and included in the computation of capital. The said decisions proceeds on the basis of a broad distinction between a reserve and a provision, and has stated that if the amount has been set apart for meeting a further liability, it is a reserve and if it is one to meet a current and existing liability, it is a provision. But this broad distinction is no longer accurate in view of the decision of the Supreme Court in Vazir Sultan Tobacco Co. Ltd. v. CIT : 132ITR559(SC) , where the Supreme Court had pointed out the difference between a provision and reserve and stated that a conjoint reading of the definition of 'reserve' and 'provision' in the Companies Act, 1956, show that if any retention or appropriation of a sum falls within the definition of 'provision', it can never be reserve, but it does not follows that if the retention or appropriation is not a provision, it is automatically a reserve, that the question will have to be decided having regard to the true nature and character of the sum so retained or appropriated, depending on several factors including the intention with which and the purpose for which the said retention or appropriation has been made, because the substance of the matter is to be regarded and that, in this context, the primary dictionary meaning of the word 'reserve' may have to be availed of and if any retention or appropriation of a sum is not a provision, i.e., it is not designed to meet depreciation, renewals or diminution in the value of the assetss or any known liability, the same is not necessarily a reserve. The question whether the concerned amounts constitute 'reserves' or not will had to be decided by having regard to the true nature and character of the sums so appropriated depending on the surrounding circumstances particulraly the intention with which and the purpose for which such appropriations and been made. The following aspects may provide some guidelines: (1) A mass of undistributed profits cannot automatically become a reserve and somebody possessing the requisite authority must clearly indicate that a portion thereof has been earmarked or separated from the general Mass of profits with view to constituting it either a general reserve or a specified reserve, (2) the surrounding circumstances should make it apparent that the amount earmarked or set apart is in facts a reserve to be utilised in future for a specific purpose and on a specified occasion, and (3) a clear a conduct on the part the directors in setting apart a sum from out the a mass of undistributed profits avowedly for the purpose of distribution as divided in the same year would run counter to any intention of making that amount a reserve. Thus, any amount set apart for diminution in the value of the assets which is a known liability can only be take to be a provision and not a reserve. The said decision of the Supreme Court was rendered subsequent to the decision of the Tribunal. In the face of the said decision of the Supreme Court, the decision in CIT v. British India Corporation (P.) Ltd. : 92ITR38(All) has to give way. As a matter of fact, even before the said decision of the Supreme Court, the Calcutta High Court in Upper Ganges Sugar Mills Ltd. v. CIT : 129ITR438(Cal) , has taken the view that the reserve brought into existence by creating or increasing (by revaluation or otherwise) any book assets is not capital for computing the capital of a company as it is only a provision. Of course, the decision of the court rested on Explanation 1 to rule 2 of the Second Schedule to the Act. We have, therefore, to hold that so far as the assets replacement reserve is concerned, it cannot be included in the computation of the capital for the purpose of surtax.
10. Then, we come to the debenture redemption fund. Normally debentures are treated as debts borrowed and as such it will not form part of the capital of the company. Gore-Browne, in the his treatise on Joint Stock Companies, 41st edition at page 266, says:
'Although moneys raised by debentures or on loans are capital moneys, they do not form part of the share capital of the company, but are loan to and a debt due from the company, and interest is payable whether there are or are not profits.'
11. It is seen from rule 1(iv) of the Second Schedule which sets out the rules for computation of the capital of a company for the purpose of surtax as originally enacted in 1964, that the debentures themselves are to be included it the capital of the company for the purpose of surtax. However, the Finance Act of 1973, restricted with effect from April 1, 1974, the scope of that rule to debentures issued to the public and which are not redeemable before the expiry of a period of seven years from the date of issue. Later, the Finance Act of 1976, with effect from April 1, 1977, has altogether excluded debentures from the capital base by deleting sub-rule (iv) of rule 1 of the Second Schedule. Thus, in the relevant assessment year, debentures are not includible in the capital for the purpose of surtax. Once debentures are not included in the capital of the company, then there cannot be an inclusion of debenture redemption fund created by the assessee to liquidate the debentures issued. We have therefore, to hold that the debenture a redemption fund is not includible in the capital of the company for purposes of surtax.
12. So far as the staff retirement gratuity reserve is concerned, it has to be noted that the Supreme Court held in Vazir Sultan Tobacco Co. Ltd. v. CIT : 132ITR559(SC) , that the gratuity liability calculated each year as per the scientific or actuarial method can be taken to be a present liability and, therefore, it could be taken to be a debt due by the company and hence it is included as part of the capital. However, at page 574, it has observed that if the retirement gratuity reserve exceeds the amounts determined on the basis of the actuarial valuation, it should be taken to be an excess provision and, therefore, only the excess provision should be treated as a reserve. Therefore, the amount set apart in excess of the actual liability for gratuity will alone be included as part of the capital.
13. In this view, the question referred in T. C. No. 375 of 1978 is answered in the negative and in favour of the Revenue and the question in T. C. Nos. 320 and 321 of 1978 is partly answered in favour of the assessee as regards the excess amount set apart in the staff retirement gratuity reserve over and above the actual liability determined in accordance with the actuarial a method and partly in favour of the Revenue as regards the assets replacement reserve and debenture redemption fund which we have held to be not includible in the capital. The Revenue will get the costs from the assessee. Counsel's fee Rs. 500 (one set).