BALASUBRAHMANYAN J. - This reference from the Income-tax Appellate Tribunal raises a point about the treatment of a so-called reserve for gratuity in the computation of capita under the Second Schedule to the Super Profits Tax Act, 1963.
The question arose in the assessment of M/s. Crompton Engineering Co. (Madras) Ltd. They claimed that a sum of Rs. 7,75,000 which figured as a 'reserve' for gratuity on the liability side of their balance-sheet as on December 31, 1961, must be reckoned as part of the their capital for purpose of capital computation under the Second Schedule to the Act. The ITO rejected the assessee claim. His reason for doing so, along with similar reasons for disallowing the assessee claim under another head, were as under:
'The reserve for gratuity of Rs. 7,75,000 and the reserve for bad and doubtful debt of Rs. 48,872 cannot, in my opinion, be termed as reserves. In fact, the assessee itself has shown the reserve for gratuity as a provisions of gratuity and has included it under the head Current liabilities and provisions. The provision for bad and doubtful debts has been deducted from the sundry debtors balances shown on the assets side of the balance-sheet. These balances standing to the credit of the accounts would fall into the category of provision made to meet the continent liability and hence cannot form part of the general reserve of the assessee-company. Once these have been identified with, and made available for particular liability which the company would have to meet, then there is no point in reading them as reserve.'
The Tribunal, however, allowed the assessees claim on appeal. The Tribunal held that the amount of Rs. 7,75,000 must be regarded as a reserve and must be added to the paid-up capital of company for the purpose of capital computation under the Second Schedule. In this reference at the instance of the Department, the questions for our consideration is:
'Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that the reserve for the gratuity of Rs. 7,75,000 should be taken into account in determining the capital base for the super profits tax assessment fort the assessment year 1963-64 ?'
An identical question was considered by the Supreme Court in recent decision. It is reported in fulls in Vazir Sultan Tobacco Co. Ltd. v. CIT : 132ITR559(SC) . The law laid down by the Supreme Court in that case may be summarized in our own words, in the following propositions:
Proposition 1: There is a well-merited distinction between a reserve and a provision.
(a) A reserve is a stand-by created out of profits of a business to meet contingencies which are unknown and which cannot be foretold on the basis of knowledge of current facts. A reserve is created by way of appropriation, it does not go out of the business, but is retained in the business as part of its capital.
(b) A provision, on the other hand, is a charge against profits. It is created to meet liabilities, which are know and foreseeable, but whose exact timing, and hence whose quantification, alone, are uncertain, at the moment.
proposition 2: Gratuity for employees is a defiant liability of the business, although when exactly it would have to be paid actually is dependent upon several contingencies. It is, however, not impossible to provide, here and now, for the liability so as to meet the situation easily as the when it arises. When such a provision is made, it is a definite liability, provided it is done on scientific principles. In such case, the provision made will be a proper charge against profits of the year in which the provision is made. In this sense, m it is a provision. And since it is a provision it cannot be a reserve.
Proposition 3: To provide for gratuity liability, an employer may pursue one or other of the three courses of action:
(i) He may set aside a lump sum ad hoc as a provision for gratuity.
(ii) He may consult an actuary or other actuarial expert and arrive ar a fairly accurate appraisal, on a scientific basis, of the present cost of further commitments of gratuity and then make a provision in the balance-sheet of just that amount and nothing more.
(iii) The employer may get an actuarial determination of liability, but while making an appropriation of the profits and retention thereof in the balance-sheet, he may make a provision which is in excess of the actuarial determination.
proposition 4: In case (i), the ad hoc amount provided in the balance-sheet although note on an actuarial basis, is nevertheless a provisions, and, therefore, it is a charge against pr ofits. Merely because the provision is ad hoc, it cannot be regarded as a reserve. It is still a provision for a liability which is certain and foreseen; only, it is an ad hoc provision.
In case (ii) also, the liability is foreseen and, what is more, it is currently ascertained on an actuarial calculation as to the exact amount to be set aside. Hence, this is a fortiori case ;the amount set aside is clearly a current liability and a provision. Cases (i) and (ii) must thus be regarded as 'provisions' and not as 'reserves' Cases (iii) is of an amount capable of break-up or dissection. It comprises the amount of liability determined on an actuarial a valuation plus an amount over and above the actuarial figure. To the extent it represents the amount arrived at by actuarial valuation, it is a provision and has to be dealt with as a charger against current profits. But to the extent the provision is made in the balance-sheet over and above the actuarial valuation, what has been retained cannot, in strictness, be regarded as a provision. By whatever name called, the excess credit is really a reserve, because it is over and above what has been determined as a proper charge against current profits.
It may be observed that the Supreme Court have laid down the law, in the terms aforesaid, on the basis of first principles of corporate accounting and also on the basis of the provisions of Part III of Schedule VI to the Companies Act, 1956. In the opinion of the Supreme Court, the conception of a reserve under the Second Schedule to the act is in accordance with the provision of the company law. The court, however, uttered the caution that while a 'provision', as such, is the very antithesis of a 'reserve': it will not be true to say that whatever is not a 'provision' must automatically be regarded as a 'reserve'. They observed that even where the retention of profits in a given case does not come within the category of 'provision', in the sense that it does not involve a charge against profits, yet it may fail to qualify as a 'reserve'. According to the Supreme Court, it would be necessary in such a case to go into the nature and character of the appropriation, the intention and proposes of e appropriation, and other surrounding circumstances, to decide whether it is a 'reserve' in the sense that it stays put as part of the proprietors that is, the companys capital.
Having made these points, the Supreme Court remanded the case before them to the Tribunal to find out whether whats was provided for by the assessee in its balance-sheet was really an ad hoc provision for gratuity, or whether it was an actuarial provision, or whether the actual amount set apart in the balance-sheet was in excess of the actuarial provision and if so, to what extent. The Supreme Court directed the Tribunal to decide about the nature of the provision or part thereof, as the case may be, on a consideration of all these relevant factors.
In the course of the argument before us in the present case, three decisions of our High Court were cited. All of them happened to be rendered before Supreme Court rendered their decision on the subject in the Vazir Sultan case : 132ITR559(SC) . The decision of this court are: (1) CIT v. Indian Steel Rolling Mills Ltd. [ : 92ITR78(Mad) ; (2) Mettur Industries Ltd. v. CIT : 114ITR439(Mad) and (3) Lucas India Service Ltd. v. CIT : 129ITR89(Mad) . In each of these cases, the amount in question which had been set apart for gratuity liability was an ad hoc amount, not based on actuarial valuation. Nevertheless, the court held, every time, that the amount retained or set apart was a reserve.
We have earlier summarised the Supreme Courts ruling according to which if an appropriation towards gratuity is ad hoc, then it must be regarded as a provision in its entirely and no part to is can be regarded as a reserve. The decision of this court in the three cases are, therefore, incorrect. In the last of the cases, it was observed by this court that since the amount set apart for gratuity liability was to based on actuarial valuation, but ad hoc, it must be regarded as a reserve. The Supreme Court, as we have earlier observed, have made no distinction between an valuation on the contrary, they regarded both as provision, and neither of them as a reserve.
It only remains to consider how this reference should be dealt with in the light of the decision of the Supreme court. The order of the ITO and those of the appellate authorities do not show whether the appropriation made in this case was an out and out ad hoc amount, or a precise amount recommended by actuarial valuation, or an amount which spills over and above the figure based on actuarial valuation. The Supreme Court decision shown that the character of the appropriation for gratuity liability will really depend on whether the amount in questions is purely ad hoc, or whether it is a lump sum over and above the actual actuarial figure of liability. As we earlier pointed out, an amount of Rs. 7,75,000 has been set apart in the balance-sheet of the assessee in the case, but it is not known whether this lump sum appropriation is of one kind or the other. In this state out knowledge, we are in a position to answer the questions of law referred to us one way or the other. The Tribunal, however in its order, had taken the view that 'it is part of the capital bases', in other words, that it is a reserve. But this conclusion has been come to by them without examining the nature of the appropriation along the lines laid down in the decision of the Supreme Court. The Tribunals order cannot therefore, be supported. We must accordingly answer the question in the negative. This answer of ours, however, necessarily implies that the matter has got to be considered again by the Tribunal in e light of the principle laid down by the Supreme Court, as summarised by us in the forgoing paragraphs. The Tribunal may, if they deem fit, remand the case to the ITO or they may call for a report from him; or they may allow the parties to adduce additional evidence on this aspect. The choice must be left to the Tribunal to be made on the basis of the balance of convenience.
The reference is disposed accordingly. In the circumstances of the case, there will be no order as to costs.