1. In all these references, the following questions have been referred at the instance of the assessee :
'1. Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the reduction in the value of the closing stock by reason of deductions from the stock-in-trade, namely, Rs. 46,79,523 for 1966-67, Rs. 4,55,283 for 1967-68, Rs. 4,23,983 for 1969-70 and Rs. 4,47,721 is not a reserve for the purpose of computation of surtax
2. Whether, on the facts and in the circumstances of the case, the amounts of Rs. 11,963 for 1966-67, Rs. 21,801 for 1967-68, Rs. 63,937 for 1969-70 and Rs. 89,098 for 1970-71 representing the provisions for specific doubtful debt deducted from sundry debtors and not allowed as a deduction in the computation of income could be claimed as a reserve as per rule 1 (iii) of the Second Schedule
3. Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the reserve for bad debt and doubtful debts and reserve for retirement gratuity should be taken into account for the purpose of capital computation ?'
2. We shall take up for consideration questions Nos. 2 and 3 before we go onto question No. 1. The relevant assessment came to be made under the Companies (Profits) Surtax Act. The assessment years involved are 1966-67, 1967-68, 1969-70 and 1970-71. The relevant previous years are those ending with 31st July, preceding those years, except with reference to the assessment year 1970-71 for which the previous year ended on March 31, 1970. The assessee claimed that in the computation of the capital the following amounts should be included as reserves. 1966-67-Rs. 89,946; 1967-68-Rs. 89,776; 1969-70-Rs. 88,353 and 1970-71-Rs. 1,03,352. The ITO did not allow this claim on the ground that these were only provisions and not reserves. On appeal, the AAC confirmed the order of the ITO. The assessee appealed to the Tribunal contending that these sums have to be treated as reserves in accordance with the decision in CIT v. British India Corporation (P.) Ltd. : 92ITR38(All) . The departmental representative, on the other hand, contended that the actual claims before the ITO for two of the years, namely, 1967-68 and 1969-70, were only Rs. 67,975 and Rs. 24,416, respectively. This difference was sought to be explained by stating that the reserve for bad and doubtful debts had been adjusted with reference to the provision for doubtful debts and that, therefore, there was difference in the figure claimed. The actual reserves after adjustment in the accounts were as follows : 1966-67-Rs. 78,383; 1967-68-Rs. 67,975; 1969-70-Rs. 24,416 and 1970-71-Rs. 14,254.
3. The Tribunal took into account the explanation given by the assessee and held that the sums shown as reserves for bad and doubtful debts in the balance-sheet alone would qualify for being considered as capital. The sums deducted from the sundry debtors was considered to be a specific provision for a known liability. In this view, the Tribunal did not treat that portion as a reserve. The result was that the assessee's claim was accepted in part and rejected in part. As far as the rejection is concerned, the assessee has come forward with question No. 2 and the department has come forward with a reference to the rest of the amount having been treated as reserve by raising the third question.
4. The Bombay High Court in CIT v. Golder Tobacco Co. Ltd. : 108ITR453(Bom) has considered a more or less similar question. In that case the assessee followed a systematic method of transferring an ad hoc amount to the doubtful debt reserve account each year. The amount so transferred was not computed on the basis of the debts that were excepted to become bad during the relevant year or even in future. The assessee did not also claim the deduction of this amount so transferred to the reserve account in the computation of its total income nor had the ITO allowed it as a deduction. The debts which became bad during the relevant years were debited directly to the profit and loss account and not to the doubtful debt reserve account. There was a large amount which stood accumulated to the doubtful debt reserve account and this was transferred to the general reserve. The assessee-company claimed that the balance in the doubtful debt reserve account should be included in the capital computation for surtax purposes. The ITO rejected this claim on the ground that the amounts transferred to the 'reserve accounts' were not 'free reserves' but were held for a specific purpose. THe AAC disagreed with this view and accepted the assessee's claim and the Tribunal confirmed the order of the AAC. The matter was thereafter taken on reference to the Bombay High Court and it was held that the Tribunal was right in taking the view that the amounts in the doubtful debt reserve account were includible in the computation of the capital of the company as reserves. The distinction between 'provisions' and 'reserves' was taken into account and it was pointed out that, in the case before the court, ad hoc amounts were transferred to the doubtful debts reserve account irrespective of the question whether individual debts had become doubtful or not.
5. We agree with the view of the Bombay High Court and in the light of the principles set out in the above decision, the ad hoc transfers to the bad and doubtful debt reserve account would qualify for being treated as 'reserve' while the amounts that were actually taken into account as bad debts as shown under question No. 2 would not represent reserves. They were merely provisions to that extent. The result is that the second question has to be answered in the negative and against the assessee. The first part of the third question is answered in the affirmative and against the revenue.
6. The second part of the third question relates to the treatment of the reserve for retirement gratuity. The claim of the assessee was that the following amounts should be considered as reserves : 1966-67-Rs. 8,47,765; 1967-68-Rs. 7,45,893; 1969-70-Rs. 8,27,748 and 1970-71-Rs. 8,94,068. The ITO disallowed the claim on the ground that they represented only provisions and not reserves. The AAC confirmed the order of the ITO. The Tribunal, following a decision of this court in CIT v. Indian Steel ROlling Mills Ltd. : 92ITR78(Mad) , held that the amounts set apart for payment of gratuity could be treated as reserves includible in the computation of capital. It is this part of the order of the Tribunal that is now challenged in the second part of the third question at the instance of the Commissioner.
7. In CIT v. Indian Steel Rolling Mills Ltd. : 92ITR78(Mad) , it was held that the term 'reserve' in r. 1 of Sch. II of the S. P. T. Act, 1963, which is identically worded as in the Act now under consideration, meant a sum specifically set apart for future use or for a specific occasion before the distribution of the dividends to the shareholders. The amounts set apart for payment of gratuity, a contingent and future liability, used for the purpose of the business of the company was held to be a reserve within the meaning of r. 1 of Sch II to the S. P. T. Act, 1963. This decision has been subsequently followed in Mettur Industries Ltd. v. CIT : 114ITR439(Mad) .
8. The learned counsel for the Commissioner drew our attention to our decision in T. C. No. 263 of 1975 dated 27th February, 1979-CIT v. Andhra Prabha P. Ltd. : 123ITR760(Mad) . In that case on of the questions that arose for consideration was whether the assessee was entitled to the deduction of the estimate gratuity payable to non-working journalists if it was established that the provisions for payment of gratuity was arrived at on legal and scientific basis. In that case a sum of Rs. 1,32,653 represented an estimate of accrued liability calculated on a scientific basis. The assessee claimed that this amount was allowable as deduction in its income-tax assessment. After referring to the relevant decisions bearing on the question of deductibility of the said amount in arriving at the taxable profits, it was pointed out that the very concept of profit would require adjustment being made for the claim of the employees for gratuity in so far as it is possible to relate it to the current year and that the claim made in that case was a present estimate of a future liability. It was pointed out that the amount was deductible if it was worked on a legal and scientific basis and that any arbitrary claim in this behalf could not be countenanced.
9. In that case also reference was made to the decision of this court in CIT v. Indian Steel Rolling Mills Ltd. : 92ITR78(Mad) and it was submitted that the amount under consideration in that case represented only a reserve so that it could not be deducted in arriving at the profits. It was pointed out that whether it was a provision or a reserve which was the subject-matter of the consideration in CIT v. Indian Steel Rolling Mills Ltd. : 92ITR78(Mad) was not strictly relevant in arriving at the question whether it was deductible in arriving at the taxable profits. The decision in the Indian Steel Rolling Mills' case : 92ITR78(Mad) was, therefore, distinguished.
10. The learned counsel for the Commissioner contended that when once an estimated amount to cover a future liability arrived at on a scientific basis was considered to be deductible as an allowance in arriving at the taxable profits, then it could not be treated as a reserve, as a reserve would not be an expenditure. In other words, the contention now advanced, which is the converse of what was advanced on the earlier occasion, was that it being a reserve, it could not be deducted. We are unable to agree with the submission. We do not consider that there is any question of conflict as was suggested in the course of the argument between the view taken in the Indian Steel Rolling Mill's case : 92ITR78(Mad) and the decision in CIT v. Andhra Prabha P. Ltd. (T. C. No. 263 to 1975) : 123ITR760(Mad) . As far as the C. (P) S. T. is concerned, the matter has to be considered only in the light of the question whether the amount claimed was reserve. If certain as hoc amounts had been transferred to the reserve account, then it cannot be in dispute that the amounts would represent 'reserves' as envisaged by the relevant provision in the Second Schedule. In the present case, there is nothing to show that there was any scientific evaluation and that on the basis of the said evaluation any amount was asked for as a deduction. Rule 1 of Sch. II to the C. (P.) S. T. Act provides that the capital of a company is aggregate of the amounts as on the first day of the previous year relevant to the assessment year of : (i) its paid-up share capital; (ii) reserves, if any, created for the purpose of development rebate, and (iii) 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. The present case falls within the third category mentioned in r.1. It is not in dispute that the amount has not been allowed as deduction in computing the income of the company for the purpose of income-tax. It cannot also be in dispute that the amount appears as a reserve in the accounts. Therefore, the amount would qualify for being treated as a reserve. In a case where the amount has been actually claimed as a deduction on account of its having been arrived at on a scientific basis, then it cannot be taken as reserve, because r. 1 envisages its exclusion. This is not such a case. The fact that the amount is capable of being allowed as deduction under certain conditions is no criteria. In these circumstances the second part of the second question has also to be answered in the affirmative and against the revenue.
11. We now turn to the first question. The assessee claimed that there were reserves to the following extent which should be taken into account in capital computation for 1966-67-Rs. 4,79,523; 1967-68-Rs. 4,55,283; 1969-70-Rs. 4,23,983 and 1970-71-Rs. 4,47,721. The relevant facts do not clearly appear from the order of the Tribunal or the statement of the case. But they are available in the annexures to the statement of the case. We would, therefore, refer to the annexures in setting out the further facts relevant to this point. Taking the balance-sheet as at 31st July, 1965, as typical of all the years under consideration, it if found that a sum of Rs. 4,79,522.40 appears as 'stock reserve' under the 'liabilities' side of the balance-sheet. The entries in the balance-sheet may now be reproduced.
Stock ReserveRs.Balance as perlast balance-sheet ... 4,79,522.40Les : Items sold from previous year's reserve ... 1,85,656.28------------2,93,866.12------------Ad : Current year's reserve ... 1,61,417.29------------as per contra ... 4,55,283.41------------The contra entries shoen in the balance-sheet on the assets side areas follows :Current AssetsStock-in-tradeRs.As valued and cerrified by director and secretary ... 26,41,471.64Les : Reserve as per contra ... 4,55,283.41-------------21,86,188.23Stock-in-transit at cost ... 7,31,851.58-------------29,18,039.81-------------
12. In the present order of the Tribunal, the manner in which the stock reserve was created does not find any mention. But reference is made to an earlier order of the Tribunal in S. T. A. No. 7 (Bom) of 1969-70, in the case of this very assessee for the assessment year 1965-66, in relation to the assessment under the C. (P.) S. T. Act, 1964. According to that order, the assessee-company valued, (i) its unsold stocks remaining on hand for over a year at 'nil' and (ii) its stock on hand for less than one year at cost. The stocks were thus shown at a lower valuation to the extent of the first category of stock being valued at 'nil'. The assessee claimed that this sum of Rs. 4,79,522.40 appearing as the opening balance under the head 'Stocks Reserve' in the balance-sheet as at 31st July, 1965, and similar amounts in the later years should be taken into account as 'reserves'. The ITO rejected this claim and the AAC agreed with the ITO. When the matter came on appeal to the Tribunal, the Tribunal purporting to follow the decision of the Allahabad High Court in CIT v. British India Corporation (P.) Ltd. : 92ITR38(All) , rejected the assessee's claim. the Tribunal followed also its earlier decision referred to above. It is this part of the order that is now challenged in the first question.
13. From the narration of facts mentioned above, it appears that the stock reserve represents merely a diminution of the value of the stock-in-trade which would normally be valued at cost or market value, whichever is lower. In the present case, having regard to what has been stated by the Tribunal, in the order for 1965-66, the assessee appears to proceed as if stocks of less than one year should be valued at cost and the stock which remained unsold for more than one year should be taken as 'nil'. The stock-in-trade was thus shown at a lower valuation and the stock reserve amount was merely a balancing item corresponding to the lower valuation shown with reference to the stock.
14. There was an interesting discussion before us as to whether the reserve should be created only out of the profits and through the profit and loss account alone and whether the adjustment of the stock valuation reflected in the balancing entry under the head 'Reserves' could be taken into account as a reserve at all. The matter as to whether there was any actual reserve created by the assessee-company has not actually been considered by the Tribunal. There is no discussion as to whether the requisite considerations which go into the concept of reserves would be satisfied in the present case. In the absence of a proper discussion on this point, in the light of all the entries in the balance-sheet for the several years, we do not think it possible to answer the question referred to us. It may be pointed out that in respect of the bad and doubtful debts, the reserve has been created by appropriation of the profits. How far this aspect impinges on the concept of reserves has not been examined. The Tribunal has first to decide whether there has been any creation of the reserves and whether the reserves would qualify for consideration under the C.(P.) S. T. Act. In the absence of a finding on these aspects, we have to return the reference unanswered and the Tribunal will go into the question de novo in the light of all the facts and in accordance with law. It may be pointed out that the company itself has given up this manner of adjustment of the stock-in-trade for the year ended March 31, 1970 (relevant for the assessment year 1971-72) and later when M/s. Fraser and Ross became the auditors in the place of M/s. Ferguson & Co. The Tribunal will take into account all these aspects. The reference on the first question is thus returned unanswered. There will be no order as to costs.