1. Three question of law have been referred to us by the Income-tax Appellate Tribunal. All of them relate to the computation of capital under the Second Schedule to the Companies (Profits) Surtax Act, 1964. The first question is as follows :
'Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that the sum of Rs. 8,50,000 appearing in the accounts under the head 'Provision for gratuity' should be included as a 'reserve' in the computation of the capital base for the purpose of surtax assessment for the assessment year 1964-65 ?'
3. The assessment year concerned in this reference relates to the year 1964-65 for the relevant previous year ended December 31, 1963. In the balance-sheet as on December 31, 1962, the assessee made a provision for gratuity in the sum of Rs. 8,50,000. The ITO held that since the amount had been set apart with the specific idea of meeting the assessee's liability of paying gratuity to the employees, it cannot be regarded as a 'reserve'. The Tribunal, in appeal, however, held that it was a 'reserve' and must be so regarded for the purpose of the Second Schedule to the C.(P.) S.T.Act.
4. By a mere look at the sum of Rs. 8,50,000, we can see that it is a round sum, and, therefore, it is unlikely to represent the discounted present value of the assessee's commitment to gratuity payable to the workmen. Hence, the amount cannot quality as a provision. What is more, no provision was made for the year ended December 31, 1963. If it is a provision properly so-called, then in every successive year, there would be an addition to the existing provision. This addition, incidentally, is called the 'incremental value' of the pre-existing provision for gratuity. A perusal of the balance-sheet as on December 31, 1963, shows that out of the profit for that year, on appropriation was made so as to swell the pre-existing figure, the so-called provision for gratuity, in the sum of Rs. 8,50,000. Having regard to these facts, we are satisfied that not only is the so-called provision, an ad hoc one, but it would also seem to be a one-year affair, or a unique feature of the balance-sheet as at December 31, 1962, alone. There is also no indication to show that the assessee is liable to any gratuity under any legal compulsion. There is no indication from the record as to how this provision happened, at all, to have been made in the balance-sheet.
5. In a case recently decided by the Supreme Court in Vazir Sultan Tobacco Co. Ltd. v. CIT : 132ITR559(SC) , the court held that where a provision for gratuity is made in the balance-sheet of an amount equal to the discounted present value of the assessee's commitment to pay gratuity to its workmen, drawn up on the basis of an actuarial valuation, it must be held as a provision strictly so-called and, therefore, the amount cannot be regarded as a reserve. The Supreme Court proceeded to deal with another kind of case where an ad hoc sum is appropriated from the credit balance in the profit and loss account, which is not based on any actuarial report and which does not represent the present discounted value of the assessee's commitment to pay gratuity to the workmen. In this kind of case, the ad hoc amount can be regarded only as a contingent liability. While the Supreme Court referred to the form of the balance-sheet under the Companies Act recognising even contingent liability as properly falling within the head 'current liabilities and provision', the Supreme Court, however, held that a mere ad hoc provision for gratuity cannot be regarded either as provision or as a reserve for the purpose of surtax. The Supreme Court held that where there is a lump sum appropriation as a provision for gratuity, the precise figure, according to actuarial valuation, must be arrived at and to the extent that the ad hoc provision showed an excess provision over the actuarial valuation, that excess may be regarded as a reserve. The Supreme Court, however, hastened to add that a reserve must be consciously created, and a mere appropriation of accumulated profits, without more, would not answer the description of a reserve.
6. In the present case, as we earlier observed, we do not have any detailed discussion of the circumstances under which the assessee-company appropriated Rs. 8,50,000 from the profit and loss account designated in its balance-sheet as provision for gratuity. We, therefore, find it difficult to answer this question. The Tribunal will have to examine the matter in depth and decide whether the whole or any part of the sum of Rs. 8,50,000 can be regarded as a reserve under the tests laid down by the Supreme Court in Vazir Sultan's case : 132ITR559(SC) .
7. The second question referred to us for decision is as follows :
'Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that the sum of Rs. 1,83,382 cannot be taken as a reserve for purposes of capital computation ?'
8. This sum of Rs. 1,83,382, according to the Tribunal, only represented a notional figure, being the difference between the value of the depreciable assets according to the assessee's books of account and the corresponding written down value arrived at for the same assets for the purpose of income-tax. The Tribunal pointed out that the figure of Rs. 1,83,382 does not appear anywhere in the accounts of the assessee, either as a provision or as a reserve. In the circumstances, the Tribunal held that the assessee was not entitled to treat this amount as a reserve.
9. The learned counsel for the assessee demonstrated before us that the sum of Rs. 1,83,382 represents the assets written down in the balance-sheet as compared to the depreciation allowance actually allowed under the I.T. Act. According to the learned counsel, this difference must be regarded as a 'secret reserve', which does not figure on the liabilities side of the balance-sheet, either as a specific reserve or as part of the general reserve. Learned counsel submitted that secret reserves are a well-known method of conserving profits without the outside world knowing about the thing and without dissipating the profits by way of distribution of dividends. Accordingly, such reserves must also be taken into account for computing the capital base of companies under the Second Schedule to the Surtax Act.
10. We do not accept the contention of the assessee's learned counsel. The concept of secret reserves is a familiar one to company secretaries auditors. Such secret reserves would seem to have been widely resorted to in the early days of company law and practice, especially in the drawing up of balance-sheets. But, according to recent advances in corporate jurisprudence as well as according to the express provisions in the statute, we doubt whether 'secret reserves' can have any place at the present moment in company accounts. Even if the building up of 'secret reserves' may be for the benefit of the company and, in that sense, for the benefit of the shareholders, if may be a matter for question whether such reserves answer the rigorous modern test of 'true and fair' representation of the financial affairs of the company in the balance-sheet. In any case, whatever merits 'secret reserve' may have in commercial circles and corporate enterprise, they cannot be taken into account in the matter of capital computation under the Second Schedule an overt act of creating reserves either generally or under special nomenclatures. That, as we understand Vazir Sultan's case : 132ITR559(SC) , is the ruling of the Supreme Court.
11. Apart from the principles which we have mentioned above, there is a direct decision of a Division Bench of this court in English Electric Company of India Ltd. v. CIT : 132ITR251(Mad) , in which this very question has been dealt with. It was held that the mere difference in depreciation actually provided and depreciation which is allowable under the I.T. Act cannot be regarded as a reserve for purposes of the Surtax Act. In view of this decision also, our answer to the second question must be against the assessee and in favour of the Department.
12. The last question posted in this reference for our consideration is as follows :
'Whether, on the facts and in the circumstances of the case, the Tribunal was right in law in holding that the sum of Rs. 49,177 representing reserve for bad debts could not be taken into account as reserve for computing the capital base for the assessment year 1964-65 ?'
13. On this subject, the Tribunal has stated that the amount of Rs. 49,177 figured in the accounts as a 'provision for bad debts'. The assessee, however, claimed that notwithstanding this nomenclature, the amount must be regarded as a veritable reserve. The Tribunal had had occasion to go into the nature of this account carrying the name 'provision for bad debts' not only in respect of the assessment year ended December 31, 1963, but also for three subsequent years ended December 31, 1964, December 31, 1965, and December 31, 1966. The manner in which the assessee had been dealing with this account also been stated in detail in the Tribunal's order. It is seen from the discussion of these facts that, every year, the assessee has been appropriating amounts from the profit and loss account and crediting them to the account called 'Provision for bad debts'. Whenever, in any year, bad debts had to be written off, the write-off has been done by utilising the amount in the account standing by the name of 'provision for bad debts'. However, where after the write-off of bad debts during a particular year, the account 'provision for bad debts' showed credit balance, the assessee used to transfer the entire credit balance to the profit and loss account of that year. For instance, in the provision for 'bad debts' as on December 31, 1964, there was an opening balance of Rs. 62,274. But the debts actually written off came to Rs. 53,763. The balance was transferred from the 'provision for bad debts' account to the profit and loss account. The explanation of the assessee was that since the account was only a provision, an excess credit after the write-off of the year's bad debts was no longer required and, therefore, there was transfer to the profit and loss account. The Tribunal considered that the treatment method out by the assessee towards 'provision for bad debts' showed that it was really not a reserve. According to the Tribunal, if the account was a reserve, there was no need at all to transfer any amount out of that account to the profit and loss account. The Tribunal was convinced that the so-called provision for bad and doubtful debts was intended no more than to meet the year's bad and doubtful debts and, hence, it cannot be regarded as a reserve.
14. We think the Tribunal's reasonings must be accepted as pertinent to the discussion. The Tribunal's findings show that the amount credited to the account 'provision for bad debts' does not even qualify fully for being called a provision, let alone being given the status of a 'reserve' having regard to the way in which it was treated year after year. It would appear that this provision was only a temporary one, which went in to the write-off of debts becoming bad during a year, the excess in the account being transferred to the profit and loss account. We cannot call an account a reserve account, the very foundation of which is precarious. We have of a reserve being created by appropriation from the credit balance in the profit and loss account. But it is quite a novel kind of reserve, which is a two-way traffic, as it were, and which transferred its own credit balance in the reserve account back to the profit and loss account.
15. For these reasons, we hold that the sum of Rs. 49,177 figuring in the balance-sheet as on December 31, 1962, cannot be treated as a part of the company's reserve for the purpose of computation under the Second Schedule to the Surtax Act. Our answer to the relevant question of law referred to us must, therefore, be against the assessee.
16. Before parting with this case, we may observe that our attention was invited to some earlier decisions of courts bearing on the computation provision in the Second Schedule to the Surtax Act. We were also asked to peruse a passage or two from the text books writers on accountancy. We have not thought it fit to refer to these citation since we are convinced that after the enunciation of the principles in the Vazir Sultan's case : 132ITR559(SC) , it would only be an exercise or u under a different emphasis in other legal literature.
17. To sum up our decision, the first question is remitted to the Tribunal for further consideration in the light of the observation in this judgment, the second and third questions are answered against the assessee. Since the Department has succeeded substantially in this reference, they are entitled to their costs from the assessee. Counsel's fee Rs. 500 (one set).