Full Judgment Text
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PETITIONER:
PURSHOTAM H. JADYE AND OTHERS
Vs.
RESPONDENT:
V. B. POTDAR
DATE OF JUDGMENT:
26/10/1965
BENCH:
GAJENDRAGADKAR, P.B. (CJ)
BENCH:
GAJENDRAGADKAR, P.B. (CJ)
WANCHOO, K.N.
HIDAYATULLAH, M.
RAMASWAMI, V.
CITATION:
1966 AIR 856 1966 SCR (2) 353
ACT:
Business Profits Tax Act, 1947- Schedule 11, rules 2(1) and
(3)"Premium’ and "reserves" in computation of capital under
r. 2(1)Whether cover accounts described as "capital paid in
surplus" and "Earned Surplus" according to American
accounting practice.
HEADNOTE:
The assessee company was incorporated in the State of
Delaware in the United States of America with the object of
taking over the assets of two other American companies in
return for stock in the assessee company. Upon the
acquisition, although the book value of the assets taken
over from each of the two transferor companies was
different, the two cornpanies were allotted an equal number
of shares in the assessee company. Part of this difference
was covered by issuing serial bonds ,to one of the companies
which were late redeemed. As the total book-value of the
assets taken over by the assessee company was in excess of
the par value of the stock issued to the two transferor
companies, this excess, in accordance with established
accounting practice in the United States of America, was
entered in the books of the assessee company in an account
styled "Capital paid in Surplus".
The net profits earned by the assessee company from year to
year, after certain appropriations, were also in line with
American accounting practice, shown in the balance sheet
under the caption "Earried surplus" or "Earnings
reinvested".
In proceedings for assessment under s. 4 of the Business
Profits Tax Act, 1947, the Income Tax Officer disallowed the
claim of the assessee company for the inclusion of the
accounts "Capital paid in Surplus" and "Earned Surplus" in
the computation of taxable capital under Schedule IT r. 2(1)
of the Act and the Appellate Assistant Commissioner agreed
with him. But the Tribunal, in appeal, held that the
difference between the value of the assets taken over and
the value of stock issued by the assessee company was
premium realised from the issue of its shares and retained
in the business within the meaning of rule 3 of Scb. 11 and
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was in any event reserve not allowed in computing profits
within the meaning of r. 2(1). The Tribunal also held that
the "Earned Surplus" represented reserves liable to be taken
into account in assessing business profits tax. Upon a
reference, the High Court agreed with the views of the
Tribunal.
It was contended on behalf of the Revenue, inter alia, (i)
that shares may be said to-)be issued at a premium only when
they were issued for cash in excess of par value and not
otherwise; (ii) that the amount of "Capital paid in Surplus"
could not be regarded as "reserves’ as the reserves
contemplated by r. 2(1) are only those which are built out
of profits processed for the purpose of taxation under the
Indian income-tax Act and that where a reserve is brought
into existence by creating or increasing, by revaluation or
otherwise a book asset, it cannot be included in the
computation of capital by virtue of the Explanation to r. 2;
(iii) that the: "Earned Surplus" in the balance sheets of
the asessee company
Sup. CI/66-10
368
were not reserves, as accumulated profits could only be
deemed reserves within the meaning or r. 2(1) if they were
specifically allocated to reserves and not otherwise.
HELD: (i) The High Court was right in holding that the
difference between the book value of the assets transferred
and the par value of capital stock was premium. [376 E]
In the absence of any restriction in the law of Delaware
against the issue of shares otherwise than for cash, when
shares were issued for consideration other than cash, the
value of assets transferred in excess of the par value of
shares issued would be regarded as "premium’ under the
Indian system of law. [374 F]
When shares are issued at a premium, ordinarily premium at a
uniform rate would be charged from all applicants for
shares; but on principle there is no objection to the
charging of varying rates of premium for shares issued under
a single resolution, if all the parties concerned agree.
In the present case although the book value of the assets
transferred by the transferor companies was larger than that
of the assets transferred by the other company, these two
companies agreed with the assessee company to receive stocks
of equal par value carrying equal rights. [374H; 375E]
Shares at or without premium may be issued subject to
express statutory provision to the contrary for money or
services or in consideration of transfer of property. There
was no provision in the companies Act, 1913, nor was any
shown in a statute in the State of Delware which enacted a
different rule. [376 A-B]
(ii) The amount of "capital paid in surplus" also
represented "reserves" within the meaning or r. 2(1).
Reserves built up from sources other than profits would be
admissible for inclusion in capital under r. 2(1)
Commissioner of Income-tax, Bombay v. Century Spinning &
Manufacturing Co. Ltd., 24 I.T.R. 499, referred to.
Difference between the assets received by the company and
the par value of the shares issued was not a book asset
"brought into existence by creating or increasing (by
valuation or otherwise)". These assets received by the
assessee company were real and tangible and it was only for
accountancy purposes that a part of the value of assets was
allocated to the par value of the shares and the balance to
the "Capital paid in Surplus" account. [378 A-D]
(iii) The High Court was right in holding that the
"Earned Surplus" in the assessee company’s accounts
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represented "reserves" within the meaning of r. 2(1).
In accordance with accountancy practice in the United States
of America, the balance of net profits after allocation to
specific reserves and payment of dividend is entered in the
account under the caption "Earned Surplus" and it is
intended thereby to designate a fund which is to be utilised
for the purpose of the business. Such a fund may be
regarded according to the Indian practice as "general
reserves".
First National City Bank v. Commissioneer of Income-tax,
Bombay, 42 I.T.R. 17, referred to.
The accounts of the assessee company maintained according to
the general accountancy practice prevailing in the United
States of America
369
disclosed that the balance of "Earned Surplus" it the end of
the year did not merge into the account of the subsequent
year. It represented a specific account into which were
added the net profits of the year and appropriations were
made out of it and the balance was regarded as "Earned
Surplus" at the end of the year. This account was
specifically allocated for utilisation for the purpose of
the business year after year. Therefore the conditions
regarded as essential in the Century Spinning &
Manufacturing Company’s for constituting the, "Earned
Surplus" into reserves" were fulfilled. [379G-383E-G]
JUDGMENT:
CIVIL APPELLATE JURISDICTION : Civil Appeal No. 268 of 1964.
Appeal by special leave from the judgment and order dated
January 29, 1962 of the Calcutta High Court in Income-tax
Reference No. 1.8 of 1955.
A. V. Viswanatha Sastri, N. D. Karkhanis, R. H. Dhebar and
R. N. Sachthey, for the appellant.
N. A. Palkhiwala, Ramachandran, J. B. Dadachanji, O. C.
Mathur and Ravinder Narain, for the respondent.
The Judgment of the Court was delivered by
Shah, J. At the instance of the Commissioner of Income-tax
(Central) Calcutta, the Income-tax Appellate Tribunal
referred the following questions for the opinion of the High
Court of Calcutta under s. 19 of the Business Profits Act 21
of 1947 :
"(1) Whether on the facts found the Tribunal
was right in holding that the sum of
$117,000,000 appearing in the Balance Sheet of
the assessee Company under the head "Capital
paid in Surplus" and constituting the excess
of the book value of the assets over the face
value of the shares represented premium
realised from the issue of the s
hares as
contemplated by Rule 3 of Schedule II of the
Business Profits Tax, Act, 1947.
(2) Whether on facts and in the
circumstances of the case the Tribunal was
right in holding that the fact that the amount
in question had been built up out of capital
and not out of taxed profits would not prevent
it from being reserve as contemplated by Sub-
Rule (1) of Rule 2 of the Schedule 11 of the
Business Profits Tax Act.
(3) Whether on the facts and in the
circumstances of the case, the Tribunal was
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right in holding that the sum of $29,000,000
odd, $43,000,000 odd, $56,000,000 odd and
73,000,000 & odd for the respective years
appearing in the Balance Sheets of the
assessee as,
370
"Earned Surplus" would be treated as a reserve
within the meaning of Sub-Rule (1) of Rule 2
of the Schedule 11 of the Business Profits Tax
Act."
The High Court recorded answers in the affirmative on all
the questions. The Commissioner of Income-tax has appealed
to this Court with special leave.,
The assessee Company is a non-resident. It was incorporated
in the State of Delaware in the United States of America
with the object of taking over the assets of two companies-
Socony Vacuum Oil Company and Standard Oil Company (New
Jersey). The capital of the assessee company was
$10,000,000 divided into 100,000 shares of the value of $100
each. On the date of acquisition the book values of the
assets of the two companies as recorded in their books of
account were:
Socony Vacuum Oil Company.... $97,715,701
Standard Oil Company
(New Jersey).... $46,767,397
In consideration of transfer of these assets, the assessee
company allotted to each company 49,995 shares and to Socony
Vacuum Oil Company serial bonds of the value of $13,093,000.
The remaining ten shares were divided equally between the
two transferor companies for cash at par value. The
assessee company entered in its books of account the book
value of the assets taken over from the transferor
companies. The excess of the net value of the assets so
transferred over the par value of the stock issued and the
serial bonds was entered in the books in an account styled
"Capital paid in Surplus". The serial bonds issued to the
Socony Vacuum Oil Company were later redeemed. By
adjustment entries the "Capital paid in Surplus" account was
reduced to $117,561,317 and throughout the period of three
years to which these appeals relate, in the balance sheets
of the assessee company, the "Capital paid in Surplus" stood
unchanged at that figure. The net profits earned by the
Company year after year, subject to certain appropriations
were shown in the balance sheet under the caption "Earned
Surplus" or "Earnings reinvested". At the end of 1945, the
balance of "Earned Surplus" was $29,557,597 and by the end
of 1948 the account stood at $73,766,592.
The Income-tax Officer disallowed the claim of the assessee
Company for inclusion of the accounts "Capital paid in
Surplus" and "Earned Surplus" in the computation of taxable
capital under Sch. II r. 2(1) of the Business Profits Tax
Act and the Appellate
37 1
Assistant Commissioner agreed with him. But the Income-tax
Appellate Tribunal held that the difference between the
value of the assets taken over and the value of stock and
serial bonds issued by the assessee Company was premium
realized from the issue of its shares and retained in the
business within the meaning of r. 3 of Sch. II and was in
any event reserve not allowed in computing profits within
the meaning of r. 2(1). The Tribunal also held that the
amount entered in the account "Earned Surplus" was reserve
liable to be taken into account in assessing business
profits tax. In a reference under S. 19 of the Business
Profits Tax Act, the High Court agreed with the view of the
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Tribunal on the three questions referred for its opinion.
The provisions of the Business Profits Tax Act, 1947, which
have a bearing on the questions raised in the reference to
the High Court may first be summarised By s. 4 of the Act in
respect of any business to which the Act applies, business
profits tax is charged, levied and paid on the taxable
profits during any accounting period at the rates specified
in the Act. The expression "Taxable profits" is defined in
s. 2(17) as the amount by which the profits during a
chargeable accounting period exceed the abatement in respect
of that period. "Abatement" is defined in s. 2(1) (insofar
as it is material) as meaning, in respect of any chargeable
accounting period ending on or before the 31 st day of.
March, 1947 a sum which bears to a sum equal to (a) in the
case of a company, not being a company deemed for the
purposes of s. 9 to be a firm, six per cent of the capital
of the company on the first day of the said period computed
in accordance with Sch. II, or one lakh of rupees,
whichever is greater, and (b) in respect of any chargeable
accounting period beginning after the 31st day of March,
1947, such sum as may be fixed by the annual Finance Act.
Schedule II prescribes rules for the computation "of the
capital of a company for purposes of business profits tax".
The material clauses are 2(1) and 3 :
"2. (1) Where the company is one to which rule
3 of Schedule I applies, its capital shall be
the sum of the amounts of its paid-up share
capital and of its reserves in so far as they
have not been allowed in computing the profits
of the company for the purposes of the Indian
Income-tax Act, 1922 (XI of 1922), diminished
by the, cost to it of its investments or other
property the income from which is not
includable in the profits, so far as that cost
exceeds any debt for money borrowed by it.
(2)....................................
372
Explanation.-A reserve or paid-up share
capital brought into existence by creating or
increasing (by revaluation or otherwise) any
book asset is not capital for the purposes of
ascertaining the abatement under this Act in
respect of any chargeable accounting period.
3. So much of the premium realised by a
company from the issue of any of its shares as
it retained in the business shall be regarded
as forming part of its paidup capital for the
purposes of rule 2."
The first two questions referred by the Tribunal relate to
the true nature of the amount entered in the books of
account of the assessee company under the caption "Capital
paid in Surplus". It is a common practice in the United
States of America in transactions in which business assets
are transferred to a new company, to issue shares of total
par value less than the true value of the assets
transferred. Singer, who was Treasurer of Standard Vacuum
Oil Company and officiated as Treasurer and later as Vice-
President of the assessee Company has stated in paragraph-5
of his affidavit that. "The reason for limiting the stated
or par value of the capital stock of Standard Vacuum Oil
Company to $10,000,000 rather than including the entire
capital of $131,391,098.71 in the par value of issued stock
was simply to reduce issuance taxes and fees payable on the
basis of the par value of stock issued, in view of the fact
that the stock was held by only two corporate shareholders
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and there was no need for a larger number of shares to be
issued and outstanding." In "Cases and Materials on
Corporations" by Dodd and Baker, 2nd Edn., at p. 1118 under
the head "Sources of Capital Surplus" the authors have
stated
"Credits to an account that is still generally
called Paid-in Surplus arise in a number of
circumstances which include: (a) where shares
having a par value including the very low par
value that has recently come into use, are
issued and sold for cash or non-cash
consideration in an amount in excess of
part......... The occasion for the issue may
be an initial or subsequent acquisition of
property. Such a property acquisition may be
the purchase of all or substantially all
assets of another corporation as a going
concern, or a merger by which such another
corporation is absorbed by the surviving
corporation, or a consolidation by which two
or more corporations are absorbed by a new
corporation created in the consolidation
proceedings. Upon such a purchase
373
of assets or in a merger or consolidation, the
defensible value of the assets of the vendor
or of the absorbed corporation or corporations
may not be "capitalized" in its entirety, so
that a paid-in surplus emerges from the
transaction."
In Fletcher’s Cyclopedia Corporations Vol. 19 Paragraph
9237, the author has set out the prevailing method of
carrying into the balance sheet the amount of consideration
received in excess of par value under the head "Surplus" :
"........as dividends can be declared only out
of surplus earnings, and there must be an
exact method of determining whether surplus
earnings for that purpose actually exist, it
is the view of sound attorneys and sound
accountants that the only proper method of
handling, in the accounts, the item of no par
value stock is to set up on the books, as a
charge against capital, the amount of the
consideration received for each issue of such
stock and that any other increases or any
decreases in net assets should be carried on
the balance sheet under the headings of
Surplus and Deficit, just as if the capital
charge had been made in connection with the
issuance of stocks having a par value. They
will therefore keep the capital stock entry a
constant figure, representing the amount of
consideration received for the same, and, if
the corporation earns money, they will set up,
on the liabilities side of the ’balance sheet
an item which they call "Surplus" or
"Undivided Profits." If
additional no par value stock is issued,
although, under the theory of no par value
stock, it need not be issued at the same price
as the original issue but at such price as the
directors determine to be for the best
interests of the corporation, the number of
shares issued will be added to the number of
shares outstanding and the consideration
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received for the same will be added to the
figures opposite the entry "Capital Stock,"
and thereafter the entry of capital stock will
continue to be a constant item, the
adjustments for earnings or losses being made
in the accounts of "Surplus" or "Deficit"
It is also stated :
"In some of the States the legislature has
introduced a complication by writing into the
statutes which
374
provide for the issuance of no par value
shares a provision "that, in setting up the no
par value stock on the books, a portion of the
consideration received therefor may be charged
to "Stated Capital" and a portion to "Paid-In
Surplus".
Under the statutes of Michigan, the item of
"PaidIn-Surplus" must be carried on the
balance sheet as a separate item from "Earned
Surplus" or "Undivided Profits," and such is
the policy of many accountants in the absence
of any statutory provision."
Therefore stock is issued in consideration of transfer of
assets, the par value of stock is not necessarily equal to
the value of assets transferred. Where the value of assets
transferred exceeds the par value, the difference may
appropriately be regarded as "premium" according to the
nomenclature used in India.
Under the Companies Act, 1913, shares could be issued for
cash or against transfer of property, and it is not claimed
that under the statute law in the State of Delaware a
different rule prevailed at the time when the assessee
company took over the assets of the transferor companies.
The Indian Companies Act also places no restriction upon a
company issuing shares for a consideration which exceeds the
par value of the shares, and there is no evidence on the
record that in the State of Delaware there is such a
restriction. A share is not a sum of money : it represents
an interest measured by a sum of money and made up of
diverse rights contained in the contract evidenced by the
articles of association of the Company. In the absence of
any restriction in the law of Delaware against the issue of
shares otherwise than for cash, when shares are issued for
consideration other than cash the value of the assets
transferred in excess of the par value of shares issued
would be regarded as premium for purposes of our system of
law. No serious argument has been advanced before us on
behalf of the Commissioner controverting this part of the
case.
When shares are issued to the public at a premium,
ordinarily premium at a uniform rate would be charged from
all applicants for shares. But that is not because the law
contains any prohibition against charging differential
premiums. The right of a company to charge varying premiums
in respect of blocks of shares having the same rights issued
under different resolutions is not denied, and on principle
there is no objection to the
375
charging of varying rates of premium for shares issued under
a single resolution, if all the parties concerned agree.
The amount or value which a person intending to be a
shareholder may pay in excess of the par value for acquiring
the shares of a company depends upon the contract between
the company and such a person.
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In the case under review, the two transferor companies were
willing to combine into a larger corporation, presumably to
avoid competition. The book value of the assets transferred
by Socony Vacuum Oil Company was undoubtedly larger than the
book value of assets transferred by the Standard Oil
Company. But for effectuating a combine, the two transferor
companies in a contract with the assessee company agreed to
receive stocks of equal Oar value carrying equal rights in
consideration of transfer of assets of different values. If
the excess paid by the transferor companies over the par
value of the shares received may be regarded as premium, and
we hold that it does, it is not necessary to enter into the
correctness of the submission of the assessee company that
the difference in the value of the assets transferred by the
two companies was nominal, because the Standard Oil Company
had transferred valuable "intangible assets" which had not
entered into the book valuation of its assets, and which
bridged the difference between the value of the assets
transferred by that company and the assets transferred by
the Socony Vacuum Oil Company.
Under the Companies Act, 1913, shares of a class already
issued could be issued by a company at a discount, subject
only to the conditions prescribed by s. 105A. But the Act
made no provision relating to the issue of shares at a
premium. The matter was one governed by contract between
the company and the intending acquirer of shares. In the
Companies Act 1 of 1956, certain restrictions are imposed
upon the application of premiums received on issue of shares
by s. 78. Shares could therefore be issued at a premium
under the Act of 1913 and that appears to be recognised by
the terms of s. 78(3) of the Companies Act of 1956.
It was found by the Tribunal that the amount entered in the
balance sheet as "Capital paid in Surplus" was retained in
the business of the assessee company, and the correctness of
that view was not challenged before the High Court. The
only argument advanced before the High Court on this part of
the case was that shares could be said to be issued at a
premium only when
376
they were issued for cash in excess of the par value and not
otherwise. But shares may be issued subject to express
statutory provision to the contrary for money or services or
in consideration of transfer of property, and there is no
reason to think that a different rule applies when shares
are issued at a premium. There is no provision in the
Companies Act of 1913, which enacts a different rule, and it
is not said that there is a statute in the State of Delaware
which enacts a different rule.
Counsel for the Revenue maintained that the use of the ex-
pression "premium realised from the issue of any shares" in
r. 3 of Sch. 11 implies that there must, prior to the
allotment of shares under which premium is charged, be some
arrangement for payment of consideration in excess of the
par value of shares, and in the absence of evidence to prove
such an arrangement, the capital surplus is not premium
realised from the issue of shares. No such contention was
raised at any stage in these proceedings, and a finding that
there was before the shares were issued an arrangement
between the two transferor companies and the assessee
company that the shares were to be issued in consideration
of the transfer of assets of unequal book value held by the
two transferor companies is clearly implicit in the view
expressed by the Tribunal. The High Court was therefore
right in holding that the difference between the book value
of the assets transferred and the par value of capital stock
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issued was premium.
The assessee company said that even if this amount of
"capital paid in Surplus" be not regarded as premium within
the meaning of r. 3, it is still "reserves" within the
meaning of r. 2(1). This plea found favour with the High
Court. Counsel for the Revenue raised two contentions
against acceptance of that view of the High Court : (1) that
reserves contemplated by r. 2(1) are only those which are
built out of profits processed for the purpose of taxation
under the Indian Income-tax Act; and (2) that where a
reserve is brought into existence by creating or increasing,
by revaluation or otherwise a book asset, it cannot be
included in the computation of capital by virtue of
Explanation to r. 2. In support of his first contention Mr.
Vishwanath Sastri relied upon the observations of Chagla,
C.J. in Commissioner of Income-tax v. Century Spg. & Mfg.
Company Ltd.(1) In that case the Bombay High Court held that
profits of a company not allocated to any specific head in
the balance sheet at the end of the year of account of a
company may be treated as "reserves" for the purpose of r. 2
of Sch. II of the Business Profits Tax Act, but
(1) 20 I.T.R. 260.
3 77
the judgment of the Bombay High Court was reversed by this
Court: video, Commissioner of Income-tax,, Bombay City v.
Century Spg. & Mfg. Co. Ltd.(-’). The profits of the
company had been subjected to tax, and the, question whether
an account which is built up otherwise than out of profits
of the business could be regarded as reserves for the
purpose of r. 2 did not fall to be decided in that case.
Under r. 2(1) reserves which insofar as they have not been
allowed in computing the profits of the Company enter into
the computation of capital for the purpose of r. 2(1). This
Court observed In Century Spinning & Manufacturing Company’s
case(1) :-
"Two essential characteristics must be present
before the assessee can avail himself of the
benefit of the rule, namely, that the amount
should not have been allowed in computing the
profits of the company for the purposes of
Income-tax Act and that it should be a reserve
as contemplated by the rule."
Rule 2 does not expressly say that the reserve admissible in
the computation of capital should be one built out of
profits,, and this Court did not suggest that the rule
contained such an implication. Observations made by Chagla,
C.J. in Century Spinning & Manufacturing Company’s cave 2 )
at p. 264 :
"Therefore in order to determine the capital
of the company for the purposes of this Act
you have got to take the paid-up share capital
of the company, then you have to add to it the
reserves and you have to add only those
reserves which have been subjected to
taxation"
and at p. 265
"A reserve in. the sense in which it is used
in Rule 2 can only mean profit earned by a
company and not distributed as dividends to
the shareholders but kept back by the
Directors for any purpose to which it may be
put in future",
were only made in reference to the facts of the case and
were not intended to lay down that reserves built up from
sources other than profits will not be admissible for
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inclusion in capital under r. 2(1) of the Business Profits
Tax Act. This contention is also negatived by the terms of
the Explanation. Reserves which may be brought into
existence by creating or increasing (by reevaluation
(1) 11 54] S.C.R. 203.
(2) 2) I.T.R. 260.
378
or otherwise) any book asset are expressly declared to be
not capital for the purpose of ascertaining the abatement.
If reserves which were built not out of profits were
excluded from the operation of r. 2(1), it was hardly
necessary to enact the Explanation.
The Explanation to r. 2 has no relevance in the present
case. The difference between the assets received by the
company and the par value of the shares issued cannot be
called a book asset "brought into existence by creating or
increasing (by reevaluation or otherwise)". The assets
received by the assessee company are real and tangible
assets. It is only for accountancy purposes that a part of
the value of the assets is allocated to the par value of the
shares and the balance to the "Capital Surplus brought in"
account. The High Court was therefore right in holding that
the account "Capital Surplus brought in the balance sheet
represents premium realised from the issue of its shares
within the meaning of r. 3, or in the alternative represents
reserves not allowed in computing the profits of the company
for the purpose of the Indian Income-tax Act, 1922.
The next question is whether "Earned Surplus" may be treated
as "reserves" within the meaning of sub-r. (1) of r. 2 of
Sch. 11. It is found by the Tribunal that the profits
earned year after year by the assessee company were retained
and reinvested in its business. "Earned Surplus" has, it is
true, not been called "reserve", but if it is truly a
reserve, it must be taken into account in the computation of
capital. In considering this question, it is necessary to
note certain special features of the system of accounting
obtaining in the United States of America. In the balance
sheet% of companies the assets are balanced against
liabilities, capital stock and surplus. In the company
accounts it is usual to provide for specific or special
reserves, but there is no allocation to a head called
"General reserve" in the accounts. It is also well settled
that the accounts of companies maintained under the American
system are self-contained for each year. Under the system
of accounting in vogue in India, after allocations are made
to various purposes such as outgoing, expenses and reserves,
specific and general the balance is generally carried
forward to the next year. The amount so carried forward
gets merged into the account of the next year. If the
capital and liabilities side exceeds the property and assets
side, the difference is carried forward as loss in the next
year. Under the American system of accounting, whatever
remains on hand at the end of the year is entered on the
liabilities, capital stock and surplus side as "Earned
3 79
Surplus". This was pointed out in First National. City
Bank v. Commissioner of Income-tax, Bombay(1), where Kapur,
speaking for the Court observed :
"There is a difference between the system of
accounting of banking companies in India and
the United States : . . . . In India at the
end of a year of account the unallocated
profit or loss is carried forward to the
account of the next year, and such unallocated
amount gets merged in the account of that
http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 11 of 14
year. In the system of accounting in the
U.S.A. each year’s account is self-contained
and nothing is carried forward. If after
allocating the profits to diverse heads
mentioned above any balance remains, it is
carried to the "Undivided Profits" which
’become part of the capital fund. If in any
year as a result of the allocation there is a
loss the accumulated Undivided Profits of the
previous years are drawn upon and if that fund
is exhausted the banking company draws upon
the surplus. In its every nature the
Undivided Profits are accumulation of amounts
of residue on hand at the end of year of
successive periods of accounting and these
amounts are by the prevailing accounting
practice and the Treasury directions regarded
as a part of the capital fund of the banking
company."
It is true that the Court in that case was dealing with a
case of a banking company. But the characteristics noted
are not peculiar to accounts of a banking company : they are
applicable with appropriate variations to accounts of all
companies, and different nomenclatures are used in the
accounts to designate the residue on hand as "Surplus",
"Undivided Profits", or "Earned Surplus".
Where the balance of net profits after allocation to
specific reserves and payment of dividend are entered in the
account under the caption "Earned Surplus", it is intended
thereby to designate a fund which is to be utilised for the
purpose of the business of the assessee. Such a fund may be
regarded according to the Indian practice as "general
reserves".
The Appellate Tribunal held that the "Earned Surplus" in the
balance sheets of the assessee company represented
"reserves" within the meaning of r. 2 Sch. 11 of the
Business Profits Tax Act. The High Court agreed with that
view. But counsel for the Revenue contended that
accumulated profits could only be
(1) [1961] 3 S.C.R. 371.
380
deemed reserves for the purpose of the Business Profits Tax
Act, if they are specifically allocated to reserves and not
otherwise and in support of that contention, he relied upon
the decision of this Court in the Century Spinning &
Manufacturing Company Ltd.(1) Counsel pointed out that in
that case this Court reversed the decision of the High Court
of Bombay in which accumulated profits were regarded as
reserves for the purpose of the Business Profits Tax Act.
It is necessary carefully to scrutinise the facts in the
Century Spg. & Mfg. Company’s case(1). For the account
year ending December 31, 1945, the profit of the assessee
company, amounted to Rs. 90,44,677/-. After providing for
depreciation and taxation there remained an unallocated
balance of Rs. 5,08,637/- which was not allowed in computing
the profits of the assessee for purpose of income-tax. In
February 1946, the directors recommended that out of that
amount a sum of Rs. 4,92,426/- be distributed as dividend
and the balance of Rs. 16,21 1 /- be carried forward to the
next year’s account. The recommendation was accepted by the
shareholders and dividend was shortly thereafter
distributed. In computing the capital of the assessee
company on April 1, 1946 under the Business Profits Tax Act,
1947, the assessee claimed that Rs. 5,08,637/- carried
forward into the account of 1946 should be treated as
http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 12 of 14
"reserve" for the purpose of r. 2 ( 1 ) of Sch. 11. This
Court negatived the contention. Ghulam Hasan, J., speaking
for the Court observed
"On the 1st of January, 1946, the amount was
simply brought from the profit and loss
account to the next year and nobody with any
authority on that date made or declared a
reserve. The reserve may be a general
reserve
or a specific reserve, but there must be a
clear indication to show whether it was a
reserve either of the one or the other kind.
The fact that it constituted a mass of
undistributed profits on the 1st January,
1946, cannot automatically make it a reserve.
On the 1st April, 1946, which is the
commencement of the chargeable accounting
period, there was merely a recommendation by
the directors that the amount in question
should be distributed as dividend. Far from
showing that the directors had made the amount
in question, a reserve, it shows that they hid
decided to ear-mark it for distribution as
dividend."
After referring to the judgment of the High Court, the
learned Judge observed :
(1) [1954] S.C.R. 203.
381
"The directors had no power to distribute the
sum as dividend. They could only recommend,
as indeed they did, and it was upto the
shareholders of the company to accept that
recommendation in which case alone the
distribution could take place. The
recommendation was accepted and the dividend
was actually distributed. It is, therefore,
not correct to say that the amount was kept
back. The nature of the amount which was
nothing more than the undistributed profits of
the company, remained unaltered. Thus the
profits lying unutilized and not specially set
apart for any purpose on the crucial date did
not constitute reserves within the meaning of
Schedule 11, rule 2(1)."
It was pointed out that under the Indian Companies Act,
1913, the directors are enjoined to attach to every balance
sheet a report with respect to the state of the company’s
affairs and the amount, if any, which they 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. It was also pointed out that S. 132 of the
Indian Companies Act refers to the contents of the balance
sheet to be drawn up in the Form marked ’F’ in Sch. HI, and
to Regulation 99 of the 1st Sch. Table A, and observed that
any sum out of the profits which is to be carried into a
reserve must be set aside before the directors recommend any
dividend. The Court observed:
"In this case the directors while recommending
dividend took no action to set aside any
portion of this sum as a reserve or reserves.
Indeed they never applied their mind to this
aspect of the matter. The balance sheet drawn
up by the assessee as showing the profits was
prepared in accordance with the provisions of
the Indian Companies Act. These provisions
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also support the conclusion as to what is the
true nature of a reserve shown in a balance
sheet."
The Court was dealing in that case with the accounts of an
Indian Company, the balance sheet of which was prepared
according to the provisions of the Indian Companies Act,
1913. Regulation 99 of the 1st Sch. Table A, required that
reserves must be set apart before the directors recommended
any dividend, but out of the profits of the company no
amount was set apart towards reserves before the directors
recommended payment of dividend to the shareholders. ’Me
identity of the amount remaining on hand at the foot of the
profit & loss account was not preserved.
382
It is on these facts that the Court held that there was no
allocation of the amount to reserve and from the mere fact
that it was carried forward in the account of the next year
and ultimately applied in payment of dividend, it could not
be said to ’be specifically set apart for any purpose at the
relevant date i.e., the end of the year of account.
We are in this case dealing with a foreign company and the
system of accounting followed by the company is different in
important respects from the system which obtains in India.
Companies in India maintain diverse types of reserves : some
may be specific reserves, such as capital reserve, reserve
for redemption of debentures, reserve for replacement of
plant and machinery, reserve for buying new plant to be
added to the existing ones, reserve for bad and doubtful
debts, reserve for payment of dividend, and general reserve.
Depreciation reserve within the limit prescribed by the
Income-tax Act or the rules thereunder is the only reserve
which is a permissible allowance in the computation of
taxable profits. In its ordinary meaning the expression
reserve’ means something specifically kept apart for future
use or for a specific occasion. The accumulated profits of
the assessee company according to the system of accounting
at the end of the year were not carried forward into the
account of the next year as they could not be, according to
the system of accounting prevalent in the United States.
They had to be allocated to some account, and they were
allocated to "Earned Surplus", which was intended for and
was used in subsequent years for the purposes of the
business of the assessee company. The account in which this
amount was carried retained its identity year after year.
In the First National City Bank’s case(1), this Court held
that the undivided profits brought into account of the
assessee Bank under the head "Assets, capital, capital stock
and reserves" were reserves within the meaning of r. 2(1) of
Sch. II of the Business Profits Tax Act. In that case the
Court was dealing with a case of a banking institution, and
a letter from the Deputy Controller of Currency, Washington,
was tendered in evidence which explained that in the United
States the "Undivided Profits" as reflected in the
accounting of a bank actually represent a part of its
capital funds, and that the term "Undivided Profits" simply
followed a bank accounting nomenclature used to designate
profits set aside after provisions for expenses and taxes,
dividends and reserves, for continuous future use in the
business of the Bank.
(1) [1961] 3 S.C.R. 371.
383
In the case before us we have no such evidence on the record
about the nature of the "Earned Surplus" account, but the
manner in Which the balance sheets year after year are
maintained, and the general accountancy practice prevailing
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in the United States, suggest that there is specific
allocation of the balance of profits ,at the end of each
accounting year.
The following table prepared from the balance sheets and
filed on behalf of the assessee company, (correctness of
which has been accepted), clearly supports that view.
---------------------------------------------------------
Earnings Appro- Earnings Fixed
Year Reinvested Net priations Reinvested Assets
Earned Profit (made (Earned (at cost)
surplus) within Surplus)
Opening year) Closing
Balance Balance
-----------------------------------------------------------
$ $ $ $
-----------------------------------------------------------
945 16299765 13257841--295575977654167
1946 29557597 243553701000000043912958 82534231
1947 43912968 228618371000000056774805 110767579
1948 56774805 369917872000000073766592 19672)177
1849 73766592 388825892000000092649181 2)7045227
-------------------------------------------------------------
The Table disclosed that the balance of "Earned Surplus" at
the end of the year did not merge into the account of the
subsequent year. It represented a specific account into
which were added the net profits of the year and
appropriations were made out of it and the balance was
regarded as "Earned Surplus" at the end of the year. This
account was specifically allocated for utilisation for the
purpose of business year after year. It was an account in
which the net profits less the appropriations were added,
and the account was intended for application in extending
the business of the assessee company. The amounts entered
in the account ’Earned Surplus" cannot therefore be regarded
as mere unallocated profits at the end of the accounting
year.
The High Court was therefore right in holding that the
"Earned Surplus" represented reserves. The method in which
the accounts are maintained in the light of the accountancy
practice clearly indicates that at the end of each year,
there have been specific appropriations in the account, and
the conditions which this Court regarded as essential in the
Century Spinning & Manufacturing Company’s case(1) for
constituting the fund into reserve are fulfilled.
The appeals fail and must be dismissed with costs. There
will be one hearing fee.
Appeals dismissed.
(1) [1954] S.C.R. 203.
2SUP.C.I./6611
384