1. The controversy in this reference arises out of proceedingstaken under Section 23A of the I.T. Act, 1922, against N. Guin & Co. (P.) Ltd.,Calcutta, the assessee, in the assessment year 1960-61, the relevant previous year being the calendar year 1959.
2. The facts found and/or admitted are, inter alia, that in the said assessment year the assessee was assessed to income-tax on a total income of Rs. 1,49,004. After deduction of the taxes payable the distributable surplus was found to be Rs. 1,02,323. The assessee, a private limited company, was required to distribute 65% of such surplus, i.e., Rs. 66,510, as dividend. The assessee, however, declared a dividend of only Rs. 5,000.
3. The assessee contended that its total income as computed included capital gains of Rs. 1,35,80.8 which was not to be taken into account for the purposes of Section 23A, This amount was not a part of its commercial profits and had been shown in the accounts as a capital reserve.
4. The ITO did not accept the contentions of the assessee. He found that there was no prohibition in the memorandum or the articles of the assessee which barred the distribution of such gains and that the said amount was ' a surplus which had actually been realised. Holding that the assessee should have declared proportionate dividend out of the entire surplus including that arisen out of capital gains he passed an order under Section 23A levying additional super-tax on the undistributed amount.
5. Being aggrieved, the assessee preferred an appeal to the AAC, where it was contended that under Section 205 of the Companies Act, 1956, dividend could be declared only out of profits. The expression 'net profit' being defined in Section 349 of the Companies Act, no dividend could be declared out of capital gains. The AAC considered the definition of dividend in Section 2(1)(a) of the Companies Act (sic) and construed that it was wide enough to include capital gains. Accordingly, he confirmed the order of the ITO.
6. There was a further appeal by the assessee to the Tribunal. It was brought to the notice of the Tribunal that the capital gains in question had arisen upon sale of certain land purchased long ago by way of investment. The assessee's business not being purchase and sale of land it was contended that the gains arising from sale of land could not form part of the commercial profits of the assessee and, therefore, should be excluded for the purpose of application of Section 23A. The contentions of the revenue were that capital gains formed part of the total income of the assessee and there being no restriction, either in the Companies Act or in any other statute, in distributing the same as dividend, the ITO was justified in treating this gain as part of the assessee's commercial profits.
7. The Tribunal considered the law as laid down by the Supreme Court in CIT v. Bipinchandra Maganlal & Co. : 41ITR290(SC) and in CIT v. Gangadhar Banerjee & Co. (Pvt.) Ltd. : 57ITR176(SC) . The Tribunal noted that the capital gains in the instant case had not been taken to the profit and loss account but had been credited to reserves and surplus and held that it would not be prudent business practice to distribute such gains as dividend except under special circumstances as according to recognised commercial practice such gains had to be kept in reserve for the purpose of setting off capital losses which may arise in future. The Tribunal held further that this surplus arising out of the sale of land had the character of capital investment and had been obtained by way of realisation of such capital investment which could not be converted into business profits. The Tribunal concluded that on the facts it could not be said that the dividend distributed was inadequate or unreasonable and that Section 23A had not properly been applied to the facts. The order under Section 23A was accordingly set aside.
8. At the instance of the CIT, West Bengal III, Calcutta, this court under Section 66(2) of the I.T. Act, 1922, has directed the Tribunal to refer the following question of law :
'Whether, on the facts and in the circumstances of the case, the Tribunal was right in law in holding that the capital gains amounting to Rs. 1,35,808 did not form part of the assessee's business profits and accordingly the order under Section 23A of the I.T. Act, 1922, was not justified in law ?'
9. Mr. Ajit Sengupta, learned counsel for the revenue, has contended before us that according to the principles of commercial accountancy and also under the Companies Act and the law relating to companies there was no bar to capital gains being passed into the profit and loss account of a company and then distributed as dividend. He cited the following as authority for the above proposition.
(a) Practical Auditing by Spicer & Pegler (pp. 486-487):
'The question as to whether capital profits are available for the payment of dividends, and if so, under what circumstances, is a particularly important one, and there have been two cases decided, from which it will be possible to draw some general conditions. Lubbock v. British Bank of South America  2 Ch. 198.
'Held: That a profit made on the sale of a part of the undertaking of a company is available for dividend, if the articles so permit.' (b) Gore-Browne on Companies (pp. 289-290):
'Practical consideration as to dividends:
...in the absence of an expressly contrary provision in the articles, a company is in no way bound to distribute its profits 'up to the hilt'. It can carry such profits partly or wholly to reserve or other uses even though the articles do not expressly provide for this..... In practice, a company is likely to impose upon itself considerably stricter restraints than are contained in these legal rules. There are at least three ways in which such restraints may arise.
First, the memorandum or articles may eliminate or narrow down one or more of the possible sources of distributable profit. A provision, for instance, that dividends should be paid 'out of the profits of the business will, it seems, prohibit any distribution out of profit acquired on the realisation or revaluation of fixed assets, though it does not alter the rule that losses on such assets may be ignored. If the articles stipulate that the dividends are payable out of 'realised profits', estimated profits not yet ' rendered tangible for the purposes of division ' must be ignored.....
Secondly, and more significantly, the company may, as already indicated, impose stricter restraints than the law requires simply because it is almost invariably good business practice to do so. The legal rules ignore in particular the commercial importance of utilising current profits in order to wipe out any past trading losses and provide for depreciation on fixed assets. Any limited company which distributes a dividend without taking account of these additional practical considerations will not be making an illegal return of capital to its members, but the commercial risks which it is taking will be evident from the detailed accounts which it must place each year on a public register at the Companies Registry and which are obliged by law to present a 'true and fair view' of its financial position.' (c) Palmer's Company Law (21st edn.) (pp. 664-665):
'Dividend may be paid out of divisible profits though they might not be Profits in the business sense.
'.....it is legally permissible for the company to distribute dividend out of assets which do not represent profits made as the result of its trading or business. The connotation of divisible profits, or profits in the legal sense, is much wider than that of profits in the business sense; the former term includes, e.g., reserves accumulated from past profits, from capital profits.....whereas none of these items is regarded--and rightly so--by the businessman or accountant as trading profits.
In practice, however, companies, as a general rule, ascertain their profits on sound business principles, and do not distribute in dividends the whole of the profits which they may be legally entitled to' treat as such, without making at least reasonable provisions for meeting losses on capital. Indeed, unless this is done, the company's auditors may find themselves unable to satisfy themselves in accordance with Section 14 of the 1967 Act that the balance-sheet gives a true and fair view of the company's affairs or that the profit and loss account gives a true and fair view of the profit or loss.'
'.....it is clearly established by the authorities that an accretion to fixed assets, when realised, may be brought into the profit and loss account and may be divisible profits, unless prohibited by the articles of the company, a prohibitive article of that character would, e.g., be an article providing that dividends shall be paid out of trading profits' (pp. 671-672).
(d) Spicer & Pegler, 17th edn., p. 311, was cited to show that 'realised capital surpluses' can be shown in the profit and loss account or, alternatively, under reserves.
Mr. Sengupta also cited a decision of the Madras High Court in Factors (P.) Ltd. v. CIT : 98ITR105(Mad) , where the Madras High Court, after considering the English law and also a decision of the Bombay High Court in CIT v. Cannon Dunkerley & Co. Ltd. : 79ITR637(Bom) , differed from the latter and held, inter alia, as follows (p. 116): 'Whether the capital gain in a particular case is to be treated as profits available for distribution under Section 23A or a capital return would depend on the facts and circumstances of each case. We have already seen that unless there is an express or implied prohibition under the constitution of the company either under the memorandum or the articles, capital gains are distributable income. The profits realised on sale of such an investment or an asset is a real profit and not a fictional profit or a notional profit. The Supreme Court's decision in Commissioner of Income-tax v. Bipinchandra Maganlal & Co. : 41ITR290(SC) ..... is no authority for the position that even in cases where the sale price is more than the cost price and the amount, in fact, was realised and available in the hands of the assessee, it is only notional profit and not commercial profit. It is true that in certain cases capital gain would be in the nature of a return of capital itself and in those cases they would not be considered for the purpose of applicability of Section 23A. Barring such exceptional cases, we are of the view that the Income-tax Officer would be justified in considering the amounts received by way of capital gains as forming part of the profits of an assessee while exercising the powers under Section 23A of the Act. We have already held that, on the facts and circumstances of this case, it was not a capital return, but capital gain. There is no evidence to show that the directors did not declare the dividend for the reason that the same is required for replacement of the assets sold. In fact, the question referred to us does not warrant any consideration as to whether the distribution of the capital gain was a prudent action of the directors and, therefore, the non-declaration could not be said to be unreasonable.'
10. Mr. Sengupta also drew our attention to a subsequent decision of the Madras High Court in CIT v. Amalgamations (P.) Ltd. : 109ITR115(Mad) , which has followed its earlier decision in Factors (P.) Ltd. : 98ITR105(Mad) .
11. It is convenient to consider the decision of the Bombay High Court in CIT v. Gannon Dunkerley & Co. : 79ITR637(Bom) at this stage. The facts in that case were that the assessee admittedly made capital gains by the sale of a branch business and such gains were included in its income far the purpose of computation of income-tax. The ITO held that by reason of the undistributed surplus in the hands of the assessee Section 23A of the Indian I.T. Act, 1922, would apply. He rejected the contention of the assessee that the capital gains did not form part of its commercial profits. The AAC upheld the order of the ITO but the Tribunal upheld the contention of the assessee. From the order of the Tribunal there was a reference to the Bombay High Court. The High Court after considering the decision of the Supreme Court in Bipinchandra Maganlal & Co.'s case : 41ITR290(SC) and Gangadhar Banerjee & Co. : 57ITR176(SC) held, inter alia, as follows (pp. 647, 648):
'On the clear language of the section sharp distinction appears to have been made by the legislature between profits and gains of business on the one hand and capital gains on the other. Apparently, capital gains did not form part of the profits and/or gains of business'. Now, Section 23A was part of the Income-tax Act for a continuous period of long time before the 6th head of capital gains was added in Section 6 by Act XXII of 1947.....There was no taxation on capital gains for considerable number of years when Section 23A was part of the Income-tax Act.....It further requires to be recorded that admittedly the rate of tax on capital gains was and is altogether different from the rate of tax levied under the other five heads mentioned in Section 6. Super-tax is not payable in respect of capital gains. The gains made by way of capital return have been treated in the Income-tax Act altogether on a different footing from the profits and gains of business under the 4th head mentioned in Section 6. In arriving at the above findings, one may emphasise that the phrase 'profits and gains' as used in the first part of Section 6 is repeated only in the 4th head in connection with business, profession or vocation.
On the question before us, it is important to notice that the capital gains are made only accidentally and occasionally and in making such gains an assessee cannot be described as indulging in business activity and commerce. In inflationary market and/or rising market old and worn out capital assets required to be disposed of may on sale fetch better values and yet require to be,replaced by similar kinds of capital assets. The replacement would have to be necessarily made by investment of extraordinary higher,prices than laid out in the initial purchase of old assets. The question is whether accidental and occasional gains made by sale of old assets can be considered as profit of a commercial nature in connection with exercise of powers reserved under Section 23A. Can it be held that in normal commerce amounts earned by way of capital gains were intended to be distributed amongst the shareholders.....In ordinary circumstances, directors of business experience would never distribute amounts received by way of capital gains. These amounts would ordinarily be reserved for the purpose of replacement of the assets sold so as to carry on the business of the concerned company in normal manner.....properly looked at, there is no distinction of importance between the true nature of the amount taxed under the provisions of Section 10(2)(vii) and the capital gains earned. The Supreme Court held in the case of CIT v. Bipinchandra Maganlal & Co. : 41ITR290(SC) that the difference between the sale price and the cost price was notional profit and this was so in spite of the amount of the sale price being available in the hands of the assessee. For the same reason, amount earned as capital gains must be held to be notional profits. The availability of these gains in the hands of a company does not render these gains commercial profits.'
12. Dr. Debi Pal, learned counsel for the assessee, has contended on the other hand, that capital gains accruing to a company can never be equated with its true commercial profits constituting the distributable surplus and meant to be distributed as dividend. He submitted that in the instant case it has been found that the gain accrued on sale of land which formed part of the assessee's capital and not its stock-in-trade and that it was not the business of the assessee to purchase and sell land. It had also been found that the proceeds arising out of such sale was realisation of the assessee's capital investment and not its business profits. On the authority of Gannon Dunkerley & Co. : 79ITR637(Bom) and Bipinchandra Maganlal & Co. : 41ITR290(SC) , Dr. Pal contended that the controversy in the instant case was concluded in favour of the assessee.
13. The decision of the Supreme Court in Bipinchandra Maganlal & Co. : 41ITR290(SC) may conveniently be considered here. The facts in that case were that the assessee had purchased certain machinery and two years thereafter had sold the same at the price at which they were originally purchased. In its accounts the written down value of the machinery in the year in which they were sold had been entered at a figure less than the original purchase price. The difference between the original purchase price and the written down value was added back to the income of the assessee in the relevant assessment year and treated as its profit and an order was passed under Section 23A an the form then in force, viz., that the undistributed portion of the assessable income of the company as reduced by the tax payable should be deemed to have been distributed amongst the shareholders and proportionately included in the total income of each shareholder. This order was upheld by the AAC and the Tribunal. On a reference, the Bombay High Court upheld the contentions of the assessee. The Supreme Court on a final appeal construed Section 10(2)(vii) of the I.T. Act, 1922, under which the difference between the sale price ana the written down value had been added to the profits and gains of the company as an assessable income and held that this profit was a result of a fiction introduced by the Act and in fact was not a profit but a return of capital. The Supreme Court observed as follows (p. 295):
'Because this difference between the price realized and the written down value is made chargeable to income-tax, its character is not altered, and it is not converted into the assessee's business profits. It does not reach the assessee as his profits : it reaches him as part of the capital invested by him, the fiction created by Section 10(2)(vii), second proviso, notwithstanding. The reason for introducing this fiction appears to be this. Where in the previous years, by the depreciation allowance, the taxable income is reduced for those years and ultimately the asset fetches on sale an amount exceeding the written down value, i.e., the original cost less depreciation allowance, the revenue is justified in taking back what it had allowed in recoupment against wear and tear, because in fact the depreciation did not result. But the reason of the rule does not alter the real character of the receipt. Again, it is the accumulated depreciation over a number of years which is regarded as income of the year in which the asset is sold. The difference between the written down value of an asset and the price realized by sale thereof though not profit earned in the conduct of the business of the assessee is notionally regarded as profit in the year in which the asset is sold, for the purpose of taking back what had been allowed in the earlier years.....Computation of income for purposes of assessment of income-tax is based on a variety of artificial rules and takes into account several fictional receipts, deductions and allowances. In considering whether a larger distribution of dividend would be unreasonable, the source from which the dividend is to be distributed and not the assessable income has to be taken into account.....The legislature has deliberately used the expression 'smallness of profit' and not 'smallness of assessable income' and there is nothing in the context in which the expression 'smallness of profit' occurs which justifies equation of the expression 'profit' with 'assessable income'. Smallness of the profit in Section 23A has to be adjudged in the light of commercial principles and not in the light of total receipts, actual or fictional.'
14. Relying on the aforesaid decision Dr. Pal submitted that if the difference between the actual sale price and the written down value of the machinery, though assessed as income, could not be the business profits of a company, on a parity of reasoning the difference between the sale price of the machinery and their actual cost price should not be considered to be a part of the assessee's commercial profits. Dr. Pal accordingly invited us to follow the decision of the Bombay High Court in Gannon Dunkerley & Co. : 79ITR637(Bom) and hold that capital gains should not be treated as commercial profits of a company and available for distribution as dividend.
15. Dr. Pal cited another decision of the Supreme Court in Navinchandra Mafatlal v. CIT : 26ITR758(SC) and also a decision of the Allahabad High Court in Bhola Nath Kesari v. Director of State Lotteries : 95ITR171(All) , where the expression 'income' has been construed. These decisions are of little assistance in the instant case and need not be considered further.
16. Mr. Sengupta, for the revenue, in reply strenuously contended to distinguish the decision of the Supreme Court in Bipinchandra Maganlal & Co. : 41ITR290(SC) . He submitted that under Section 10(2)(vii) of the I.T. Act, 1922, the excess of the actual sale price over the written down value of a capital asset though brought to tax, was nothing but a return of the capital and did not involve any element of gain or profit. He further submitted that what the Supreme Court had laid down in that case was that the excess of the actual sale price over the written down value of the asset concerned was a notional and/or fictional profit and not an actual surplus. He submitted that capital gains on the other hand was an actual surplus or a gain realised by the owner of the capital asset selling or transferring the same.
17. Mr. Sengupta, lastly, drew our attention to the following observation of the Supreme Court in Gangadhar Banerjee : 57ITR176(SC) , construing its earlier decision in Bipinchandra Maganlal & Co. : 41ITR290(SC) , at page 183 of the report :
'This decision is binding on us and no further citation in this regard is called for. These two concepts, 'accounting profits' and 'assessable profits' are distinct. In arriving at the assessable profits the Income-tax Officer may disallow many expenses actually incurred by the assessee; and in computing his income, he may include many items on notional basis. But the commercial or accounting profits are the actual profits earned by an assessee calculated on commercial principles. Therefore, the words 'smallness of profit' in the section refer to actual accounting profits in comparison with the assessable profits of the year.'
18. Drawing inspiration from the above observations Mr. Sengupta contended that, in the instant case, capital gains came within the category ofboth the concepts 'assessable profits' and also 'accounting profit'. Beingassessable under Section 12B of the I.T. Act, 1922, the capital gains were assessable profits and being an actual realized gain they were also accounting orcommercial profits.
19. On a careful consideration of the authorities cited and the respective contentions of the parties, it appears to us that a capital gain cannot be equated with commercial profits. A capital gain is a notional and/or a deemed income under Section 12B of the I.T. Act, 1922, which reads as follows : '(1) The tax shall be payable by an assessee under the head 'Capital gains' in respect of any profits or gains arising from the sale, exchange, relinquishment or transfer of a capital asset effected after the 31st day of March, 1956, and such profits and gains shall be deemed to be income of the previous year in which the sale, exchange, relinquishment or transfer took place:.....'
20. No doubt, if a company chooses so to do, capital gains can be distributed as dividend. But the authorities cited clearly indicate that such a course is only permissive and not compulsory. The text books on accountancy as cited lay down that the choice is left to the company concerned, it can either transmit its capital gains into its profit and loss account and, thereafter, deal with the amount as profits or the same can be transferred to the reserve account and treated as reserve. The contention of Mr. Sen-gupta that the surplus which is taxed under Section 10(2)(vii) of the Indian I.T. Act, 1922, is a notional or fictional surplus whereas the surplus arising on a sale of capital asset is the actual surplus in the hands of the assessee, is not acceptable. Where a company by recording the depreciated value of its capital assets consistently year after year obtains benefit by paying a lesser amount of tax, and thereafter sells such assets at a price higher than the written down value, it cannot be said that no actual surplus accrues in the hands of the company. In our view, surplus of a similar nature accrue when a capital asset is sold at a value higher than its cost price. The profit or gain arising out of sale of a capital asset is notional in one sense as what the assessee gains on the one hand by way of higher sale proceeds, it simultaneously loses on the other hand by transfer of the capital asset. When an asset subsequent to its acquisition appreciates in value and its disposal results in a higher return it appears to us that such return will prima facie be on capital account.
21. In any event, the Supreme Court has clearly laid down in Bipin-chandra Maganlal & Co. : 41ITR290(SC) that 'smallness of the profit under Section 23A has t6 be adjudged in the light of commercial principles and not in the light of total receipts, actual or fictional' (underlined by us). The distinction which has been sought to be made by Mr. Sengupta between actual receipt and fictional receipt is of little significance in view of the above pronouncement of the Supreme Court.
22. Significantly, even the Madras High Court in Factors (P.) Ltd. : 98ITR105(Mad) did not lay down that in all cases the capital gains must be included in the distributable surplus for the purpose of distribution of dividend. It was held that in some cases a capital gain would be in the nature of the return in the capital. Without any example it is not possible to visualise in what circumstances a capital gain would be a return of capital and in what circumstances it would not be so.
23. In our view, when a company disposes of any of its capital asset and realises a price higher than its cost price resulting in a surplus then it will be for the directors to decide if such surplus would be treated as part of the profit of the company and included in the distributable surplus. If the directors of the company decide to treat the capital gains as part of the profits of the company and the amount is put back in the profit and loss account, and thereafter if only a part of such gains is distributed as dividend, it would be open to the ITO to go into the question whether a greater proportion of such gains should have been distributed. This would be an exceptional case. But where the entire surplus is channelled into reserves it is not for the ITO to lay down that it should have been treated as profits.
24. We agree with Mr. Sengupta that a capital gain is taxable as income and for the purpose of arriving at the available surplus capital gains must be taken into account. But in determining the reasonableness of the quantum of dividend, it will be only in exceptional cases, which we have discussed above, that the amount of capital gains can be taken into account by the ITO.
25. In the instant case, the admitted position is that the directors of the assessee have put the entire amount of the capital gains in reserves and no part thereof has been brought back into the profit and loss account. Accordingly, on such facts, it must be held that the amount of capital gains of Rs. 1,35,808 could not be treated as part of the business profit of the assessee in order to determine the reasonableness of the dividend declared by it.
26. The question referred is, for the above reasons, answered in the affirmative and in favour of the assessee. There will be no order as to costs.
C.K. Banerji, J.
27. I agree.