ISMAIL J. - The two questions that have been referred to this court by the Income-tax Appellate Tribunal, Madras Bench, in T. Cs. Nos. 287 and 289 of 1972 are :
'(1) Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the dividend equalisation reserve of Rs. 20,000 is reserve and accordingly includible in the capital computation for abatement in the surtax assessment for 1964-65 ?
(2) Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the dividend equalisation reserve of Rs. 90,000 is a reserve and accordingly includible in the capital computation for abatement in the super profits tax assessment for 1963-64 ?'
The assessee is the same in respect of both these tax cases (T. Cs. Nos. 287 and 289 of 1972).
In the other tax case, namely, T.C. No. 120 of 1974, in which the assessee is different, the question that has been referred to this court is :
'Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the dividend equalisation reserve of Rs. 2 lakhs credited under the head reserves and surplus in the balance-sheet of the assessee-company is reserve and as such includible in the capital computation for super profits tax assessment for 1963-64 ?'
Thus, it will be seen that T.C. No. 289 of 1972 and T.C. No. 120 of 1974 deal with the Super Profits Tax Act, 1963, while T.C. No. 287 of 1972 deals with the Companies (Profits) Surtax Act, 1964. Notwithstanding the reference to the two Acts in question it is the common case that the material provisions with which we are concerned in these references are the same. Both the Acts were enacted for the purpose of subjecting to a special tax the profits made by certain companies.
Section 4 of the Super Profits Tax Act, 1963, provided that subject to the provisions contained in that Act, There shall be charged on every company for every assessment year commencing on and from the 1st day of April, 1963, a tax (referred to as super profit tax) in respect of so much of its chargeable profits of the previous year or previous years, as the case may be, as exceeded the standard deduction, at the rate or rates specified in the Third Schedule. The expression 'standard deduction' was defined in clause (9) of section 2 of that Act as meaning 'an amount equal to six per cent, of the capital of the company as computed in accordance with the provisions of the Second Schedule, or an amount of fifty thousand rupees, whichever is greater'.
In these references we are concerned with 'standard deduction' as computed in accordance with the provisions of the Second Schedule to that Act. Paragraph 1 of the Second Schedule to that Act stated :
'Subject to the other provisions contained in this Schedule, the capital of a company shall be the sum of the amounts, as on the first day of the previous year relevant to the assessment year, of its paid up share capital and of its reserve, if any, created under the proviso (b) to clause (vib) of sub-section (2) of section 10 of the Indian Income-tax Act, 1922 (XI of 1922), or under sub-section (3) of section 34 of the Income-tax Act, 1961 (XLIII of 1961), and of its other reserved in so far as the amounts credited to such other reserves have not been allowed in computing its profits for the purposes of the Indian Income-tax Act, 1922 (XI of 1922), or the Income-tax Act, 1961 (XLIII of 1961), diminished by the amount by which the cost to it of the assets the income from which in accordance with clause (iii) or clause (vi) or clause (vii) or rule 1 of the First Schedule is not includible in its chargeable profits, exceeds the aggregate of -
(i) any money borrowed by it which remains outstanding; and
(ii) the amount of any fund, any surplus and any such reserve as is not to be taken into account in computing the capital under this rule.' The two assessees involved in T.Cs. Nos. 289 of 1972 and 120 of 1974 had created a reserve called 'dividend equalisation reserve' for the amounts referred to in the question. The point in controversy is, whether the said reserve is really a 'reserve' coming within the scope of the Second Schedule or is merely a 'provision' as contended for by the department. If it is a provision, it will not go into the computation of the capital but if it is a reserve as contemplated by Paragraph 1 of the Second Schedule to the Super Profits Tax Act, 1963, it will go into the computation of the capital for the purpose of calculating the 'standard deduction'.
The provisions in the Companies (Profits) Surtax Act are similar. However, Paragraph 1 of the Second Schedule to that Act has been recast in a different form with greater detail and the same is as follows :
'1. Subject to the other provisions contained in this Schedule, the capital of a company shall be the 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) its reserves, if any, created under the proviso (b) to clause (vib) of sub-section (2) of section 10 of the Indian Income-tax Act, 1922 (XI of 1922), or under sub-section (3) of section 34 of the Income-tax Act, 1961 (XLIII of 1961);
(iii) its 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 purposes of the Indian Income-tax Act, 1922 (XI of 1922), or the Income-tax Act, 1961 (XLIII of 1961);
(iv) its debentures, if any, issued by it to the public; and
(v) any moneys borrowed by it from Government or the Industrial Finance Corporation of India or the Industrial Credit and Investment Corporation of India or any other financial institution which the Central Government may notify in this behalf in the official Gazette or any banking institution (not being a financial institution notified as aforesaid) or any person in a country outside India :
Provided that such moneys are borrowed for the creation of a capital asset in India and the agreement under which such moneys are borrowed provides for the repayment thereof during a period of not less than seven years.
Explanation. - For the removal of doubts it is hereby declared that any amount standing to the credit of any account in the books of a company as on the first day of the previous year relevant to the assessment year which is of the nature of item (5) or item (6) or item (7) under the heading Reserves and surplus or of any item under the heading Current liabilities and provisions in the column relating to liabilities in the Form of balance-sheet given in Part I of Schedule VI to the Companies Act 1956 (1 of 1956), shall not be regarded as a reserve for the purposes of computation of the capital of a company under the provisions of this Schedule.'
Here again, the point in controversy is the same.
The Tribunal in all these cases has held, relying upon certain principles of accountancy contained in text books on accountancy dealing with the distinction between 'provision' and 'reserves', that the amounts involved in these references constitute really 'reserves' and that they come within the scope of the Second Schedule to the respective Acts so as to go into the computation of the profits. We are clearly of the opinion that the conclusion of the Tribunal is correct.
The contention advanced on behalf of the revenue proceeded on the failure to bear in mind the clear distinction between 'provision' and 'reserve' as understood on the basis of the principles of accountancy as well as companies accounts. The Tribunal has elaborately referred to various text books bearing on this question and also the definitions contained therein as to what constitutes 'provisions' and what constitutes 'reserve'. It is not necessary for us to repeat the quotations which the Tribunal has given in its order. That the term 'provision' is different from the term 'reserve' has always been recognised by statutes as well as by courts in this country and also in England. There was a time when the word 'reserve' was indiscriminately used to denote what really constituted 'provision' and also what constituted only a 'reserve'. But that indiscriminate use has now become a thing of the past, in view of the changes effected in the provisions of the Companies Act itself.
In the well-known book by Frank H. Jones Guide to Company Balance-sheets and Profits and Loss Accounts, sixth edition, there is a separate chapter, namely, Chapter IX on 'Provisions and reserves'. That Chapter opens up by stating :
'Provisions and reserves contrasted. - When the first edition of this book was published in 1938, the author strongly deplored the inadequacy of accounting nomenclature in this country which was unable to employ separate and distinct terms to denote, (1) provisions made out of profits for specific purposes, and (2) profits already earned which are set aside (i.e., reserved) for future use or for distribution. The expression reserve was loosely used to refer to either, and as they differ as widely as the proverbial chalk and cheese, the importance of designating each with a distinctive title was urged.' (page 233).
Having stated so, the author states with regard to 'provision' as follows : 'Provisions. - Provision for a specific purpose is one that has been created by a charge made against profits (i.e., before arriving at the net profit or loss) in order to provide for an anticipated expense or loss attributable to the current year, the amount of which can only be estimated.
It will be noticed that provisions are known liabilities which cannot be determined with substantial accuracy. This brings us to a distinction between, (1) liabilities accrued to the date of the balance-sheet, and (2) provisions required at that date. The yardstick here would appear to be : can the liability be determined exactly or to a very near degree of approximation If so, it is a liability. If an estimate has to be made, it is provision.'
Having said so as to what constitutes 'provision' the author proceeds to state the distinction between 'provision' and 'reserve' thus :
'The distinction between provisions and reserves is, of course, in an entirely different category. This distinction, as already emphasised, is of profound importance, and any neglect to observe it closely will undoubtedly distort the accounts and make it impossible for them to be presented in accordance with the requirements of the Act.'
Regarding 'reserves' , the author states : 'Reserves. - A reserve is that portion of a companys profits (often an appreciable portion) which is retained for future use. It consists of appropriations from profits and other surplus which have been earned in the past. i.e., amounts which are not designed to meet any liability, contingency, commitment or diminution in value of assets known to exist as at the date of the balance-sheet. The object of conserving the revenue resources of a company in this way are : -
(1) To promote financial stability, i.e., to put aside funds for a rainy day.
(2) To equalise dividends (the reserve being drawn upon in years of depression).
(3) To provide for future extensions and/or diversification and for replacement of assets at increased prices.
(4) To avoid declaring excessively high dividends in years of prosperity which might create an impression (not always justified) that commodity prices could be reduced.
(5) To meet possible losses peculiar to the character of the companys operations (e.g., obsolescence of plant, changes of habit necessitating altered production, etc.).
(6) To redeem loans (e.g., debentures) or redeemable preference shares.
(7) To set aside sums for future taxation.'
It is significant to note that the very second object for which a reserve can be created, as stated by the author, is to equalise dividends. The meaning of the expression 'dividend equalisation fund' is given in J. R. Batlibois Advanced Accountancy as follows :
'This fund is created by setting aside a portion of distributable profits in goods years as a provision for less prosperous year, so that whenever the company may not make sufficient profits to enable it to declare the usual dividend it may have recourse to this fund. The amount representing this fund need not necessarily be invested in outside securities. Even where there is not specific dividend equalisation fund, a company can always draw upon its reserve fund, if any, for the purpose of equalising dividends.'
It is with reference to such an object only that the same author, namely, Frank H. Jones, at pages 245 of his book, Guide to Company Balance Sheets and Profit and Loss Accounts, sixth edition, referred to already, points out :
'The not uncommon practice of maintaining a dividend equalisation reserve has little logic to support it since, unless this fund is separately invested outside the business, which rarely happens, there is no assurance that it would not be absorbed along with other undistributed profits in the event of adversity overtaking the company.'
It is this distinction between 'provision' and 'reserve' which was emphasised by the Cohen Committee whose recommendation led to the enactment of the Companies Act, 1948, in England. That Committee defined 'reserves' as 'any amounts which, having been set aside out of revenue or other surplus, are free in that they are not retained to meet any diminution in value of assets, specific liability, contingency or commitment known to exist at the date of the balance-sheet'. It is based on this recommendation that regulation 117 of Table 'A' of the First Schedule to that Act provided :
'The directors may, before recommending any dividend, set aside out of the profits of the company such sums as they think proper as a reserve or reserves which shall, at the discretion of the directors, be applicable for any purpose to which the profits of the company may be properly applied, and pending such application may, at the like discretion, either be employed in the business of the company or be invested in such investments (other than shares of the company) as the directors may from time to time think fit. The directors may also without placing the same to reserve carry forward any profit which they may think prudent not to divide.'
Paragraph 27 of the English Schedule to the Companies Act, 1948, of England gave the meaning of the expressions, 'provision', 'reserve' and 'capital reserve'. We are not referring to these definitions in detail because they have been substantially incorporated in the Companies Act, 1956, to which we shall now make a reference.
Regulation 87(1) of Table A of Schedule I to the Companies Act, 1956, corresponding to Regulation 117 of Table A of the First Schedule to the English Companies Act, 1948, is as follows :
'The Board may, before recommending any dividend, set aside out of the profits of the company such sums as it thinks proper as a reserve or reserves which shall, at the discretion of the Board, be applicable for any purpose to which the profits of the company may be properly applied, including provision for meeting contingencies or for equalising dividends; and pending such application, may, at the like discretion, either be employed in the business of the company or be invested in such investments (other then shares of the company) as the Board may, from time to time, think fit.'
This regulation 87(1) of Table 'A' of the First Schedule to the Companies Act, 1956, corresponds to regulation 99 of Table 'A' of the First Schedule to the Indian Companies Act, 1913. The significant thing to be noticed in our Act is the specified reference to a reserve for equalising dividends.
Section 211 of the Companies Act, 1956, provides for the form and contents of balance-sheet and profit and loss account. The said form of balance-sheet is given in Part I of Schedule VI and the form of profit and loss account is given in Part II of Schedule VI. As far as Part I dealing with the balance-sheet is concerned, there is the express heading as 'reserves and surplus'. Under that heading, several sub-headings are given, such as :
'(1) Capital reserves. (2) Capital redemption reserves. (3) Share premium account. (4) Other reserves specifying the nature of each reserve and the amount in respect thereof. Less : Debit balance in profit and loss account (if any). (5) Surplus, i.e., balance in profit and loss account after providing for proposed allocations, namely : - Dividend, Bonus or reserves. (6) Proposed additions to reserves. (7) Sinking funds.'
Paragraph 3 of Part II of Schedule VI states :
'The profit and loss account shall set out the various items relating to the income and expenditure of the company arranged under the most convenient heads; and in particular, shall disclose the following information in respect of the period covered by the account : - ........
(viii)(a) The aggregate, if material, of any amounts set aside or proposed to be set aside, to reserves, but not including provisions made to meet any specific liability, contingency or commitment known to exist at the date as at which the balance-sheet is made up.
(b) The aggregate, if material, of any amounts withdrawn from such reserves.'
Having provided for such particulars, paragraph 7(1) of Schedule VI which comes under the heading 'Part III-Interpretation' gives the definitions of the terms 'provision', 'reserve' and 'capital reserve', as follows :
'7. (1) Fro the purpose of Parts I and II of this Schedule, unless the context otherwise requires, -
(a) The expression provision shall, subject to sub-clause (2) of this clause, mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy :
(b) The expression reserve shall not, subject as aforesaid, include any amount written off or retained by way of providing for depreciation renewals or diminution in value of assets or retained by way of providing for any known liability;
(c) The expression capital reserve shall not include any amount regarded as free for distribution through the profit and loss account......'
These statutory provisions will make the distinction between provision' and 'reserve' clear and the creation of the 'reserve fund' in the present case under the head of 'dividend equalisation reserve' will certainly constitute only a 'reserve' and not a 'provision' even after taking into account the Explanation to paragraph I of the Second Schedule to the Companies (Profits) Surtax Act, 1964.
This conclusion of ours derived support from two decisions of the Supreme Court. The first is Commissioner of Income-tax. v. Century Spinning and . : 24ITR499(Bom) , wherein, with reference to regulation 99 of Table 'A' of the First Schedule to the Indian Companies Act, 1913, the Supreme Court stated (page 505) :
'Reference was made to section 131(a) and 132 of the Indian Companies Act. Section 131(a) enjoins upon the directors to attach to every balance-sheet a report with respect to the state of companys affairs and the amount, if any, which the recommend to be paid by way of dividend and the amount, if any, which they propose to carry to the reserve fund, general reserve or reserve account. The latter section refers to the contents of the balance-sheet which is to be drawn up in the Form marked F in Schedule III. This form contains a separate head of reserves. Regulation 99 of the 1st Schedule, Table A, lays down that the directors may, before recommending any dividend set aside out of the profits of the company such sums as they think proper as a reserve or reserves which shall, at the discretion of the directors, be applicable for meeting contingencies, or for equalising dividends, or for any other purpose to which the profits of the company may be properly applied........ The regulation suggests that any sum out of the profits of the company which is to be made as a reserve or reserves must be set aside before the directors recommend any dividend.'
Thus, it will be seen that according to this judgment a reserve so set apart precedes the distribution of profits by way of dividend. In the above extract, there is a reference to section 131(a) of the Indian Companies Act, 1913. The corresponding section in the Companies Act, 1956, in section 217(1) which also requires that there shall be attached to every balance-sheet laid before a company is general meeting, a report by its board of directors, with respect to -
'(a) the state of the companys affairs;
(b) the amounts, if any, which it proposes to carry to any reserves in such balance-sheet;
(c) the amount, if any, which it recommends should be paid by way of dividend.
The next decision is Metal Box Company of India Ltd. v. Their Workmen : (1969)ILLJ785SC , wherein the Supreme Court observed :
'The distinction between a provision and a reserve is in commercial accountancy fairly well known. Provisions made against anticipated losses and contingencies are charges against profits and, therefore, to be taken into account against gross receipts in the P. & L. account and the balance-sheet. On the other hand, reserves are appropriations of profits, the assets by which they are represented being retained to form part of the capital employed in the business. Provisions are usually shown in the balance-sheet by way of deductions from the assets in respect of which they are made whereas general reserves and reserve funds are shown as part of the proprietors interest (see Spicer and Peglers Book-Keeping and Accounts, 15th edition page 42). An amount set aside out of profits and other surpluses, not designed to meet a liability, contingency, commitment or diminution in value of assets known to exist at the date of the balance-sheet is a reserve but an amount set aside out of profits and other surpluses to provide for any known liability of which the amount cannot be determined with substantial accuracy is a provision : (see William Pickles Accountancy, second edition, page 192; Part III, clause 7, Schedule VI to Companies Act, 1956, which defines provision and reserve).'
We are of the opinion that, without anything more, the principle laid down by the above two decisions of the Supreme Court will themselves clearly establish that the 'dividend equalisation reserve' created by the respective assessees in these cases will constitute reserve for the purpose of the Second Schedule to the respective Acts for the computation of the capital.
Under these circumstances, we answer the question referred to the court in the affirmative and in favour of the assessee in the respective references. The assessee in the respective cases will be entitled to their costs. Counsels fee Rs. 500, one set in T. Cs. Nos. 287 and 289 of 1972.