1966 PLP 567 (PTD)

RAJAGOPALAN, J.‑What should be allowed under the head "reserves" within the meaning of rule 2 (1) in Schedule II, read with section 2(1) (a) of the Business Profits Tax Act, 1947, is the main question for determination in this reference, which arises out of the assessment of the assesses‑company to business profits tax for the chargeable accounting periods from 1st April 1946, to 31st December 1946, and from 1st January 1947, to 31st March 1947. The assesses‑company adopted the calendar year as its year of account. The balance‑sheet for the year of account ending with 31 December 1945, showed a sum of Rs. 2,00,000 as the amount appropriated to the reserve account from that year's profit; and a sum of Rs. 9,00,000 was shown as provision made in that year for the payment of income‑tax and excess profits tax. These sums the assessee claimed should be included in the reserves for computing its capital under rule 2 (1) in Schedule II for the chargeable accounting period from 1st April 1946 to 31st December 1946. In addition, the assessee claimed the inclusion of a sum of Rs. 2,73,504 which stood to its credit in the profits and loss account on 1st April 1946, and which represented the profits for the period 1st January 1946, to 31st March 1946. For the chargeable accounting period 1st January 1947 to 31st March 1947, the assessee's claim was with reference to two items shown in the balance‑sheet for the year of account ending with 31st December 1946‑(1) Rs. 50,000 the amount appropriated from that year's profit to the reserve account, and (a) Rs. 4,75,000 the provision made in that year for the payment of income‑tax business profits tax and excess profits tax. The assessee's claims which were disallowed by the depart mental authorities were upheld by the Tribunal. At the instance of the Department the Tribunal referred the following questions to this Court under section 66(1) of the Income‑tax Act read with section 19 of the Business Profits Tax Act "(1) Whether the sum of Rs. 13,73,504 or any lesser sum brought forward on 1st April 1946, from the previous year's account forms part of the company's capital within the meaning of rule 2 (1) of Schedule II of the Business Profit Tax Act in respect of the chargeable accounting period 1st April 1946, to 31st December 1946; and (2) Whether the sum of Rs. 5,25,000 brought forward on 1st January 1947, from the previous year's account forms part of the company's capital within the meaning of rule 2(1) of Schedule II of the Business Profits Tax Act in respect of the chargeable accounting period 1st January 1947, to 31st March 1947. The relevant portions of section 2 (1), and rule 2 (1) in scheduled II ran: Section 2 (1) Abatement' means, in respect of any chargeable accounting period a sum which bears to a sum equal to in the case of company . . . . . . six percent of the capital of the company on the first day of the said period computed in accordance with Schedule II, . . . . . . ." Rule 2 (1) of Schedule II: "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 . . . . . . . It was beyond controversy that the crucial dates for the determination of what was the "capital" of the company computed under rule 2 (1) to include reserves were 1st April 1946, and 1st January 1947, respectively for the two chargeable accounting periods with which we are concerned in this reference. That the sums of Rs. 2,00,000‑ and Rs. 50,000 would be reserves within the meaning of rule 2 (1), had there been a valid allocation on or before the respective dates 1st April 1946, and 1st January 1947, could not be in dispute. The learned counsel for the Department contended that there was a valid and effective allocation in each of .the chargeable accounting periods only subsequent to the dates specified by section 2 (1). Apart from the contention, that there was no valid allocation before the crucial dates, a further contention of the learned counsel for the Department with reference .to the sums of Rs.9,00,000 and Rs. 4,75,000, set apart for payment of tax, was that they were not reserves at all within the scope of rule 2 (1). The‑ learned counsel for the assessee conceded that the claim of the assessee, that the sum of Rs. 2,73,504 constituted a reserve on 1st April 1946, for the chargeable accounting period 1st April 1946, to 31st December 1046, was unsustainable in view of the decision of the Supreme Court in Commissioner of Income‑tax, Bombay City v. Century Spinning and Manufacturing Co. Ltd. ((1953) 24 I T R 499). We shall first deal with the question, when was an effective and valid allocation made of the sums with reference to which the abatement was claimed under section 2 (1) of the Act. As explained by the Supreme Court in Commissioner of Income‑tax Bombay City v. Century. Spinning and Manufacturing Co. Ltd. what we have to examine is whether any one possessed of the requisite authority indicated on or before the crucial dates, 1 st April 1947, and 1st January 1947, the manner of disposal or the destination of the funds of the. company, which constituted its profits. Was any portion of the profits specially set apart for any purpose on or before the date specified and so set apart by one having the requisite authority ? We have to set out some more facts before we answer these questions. With reference to the year of account 1945, the relevant chargeable accounting period for which commenced on 1st April 1946, the position was as follows. The relevant portion of resolution No. 2 of the board of directors at its meeting held on 15th March 1946, ran "Resolved that the balance‑sheet, the profit and loss account and the detailed statements be approved and that the profit be allocated as follows. Rs. 9,00,000 for income and excess profits taxes. Rs. 2,00,000 for reserve fund from which the deposit under section 10 of the Finance Act will be paid." Resolution No. 3 of the board of directors ran "Resolved that the draft report . . . for submission to the general meeting be approved . . . Paragraph 2 of the report of the board of directors showed that the directors recommended an appropriation of the sum of Rs. 90,000 as a provision for payment of tax and a sum of Rs. 2,00,000 for transfer to the reserve fund to provide for the deposit under section 10 of the Finance Act. A general meeting of the shareholders was held on 15th April 1946, and the second of the resolutions passed by them unanimously ran: Resolved that the directors' report, audited balance‑sheet and the profit and loss account for the year ending 31st December 1945, be approved." The resolutions ran on the same lines, with reference to the year of account ending with 31st December 1946, which had reference to the chargeable accounting period which commenced on 1st January 1947. In this case, however, the meeting of the board of directors and that of the shareholders were both after 1st January 1947, that is, 15th April 1947, and 14th May 1947, respectively. With reference to the chargeable accounting period which Commenced on 1st April 1946, the question for determination is, was an allocation to reserves made by the directors on 15th March 1946, that is, before 1st April 1946, or was it made only by the shareholders on 15th April 1946. The contention of the' learned counsel for the assessee, that only the directors were possessed of the requisite authority to order the allocation in question, is, in our opinion, well founded. Section 131 of the Companies Act enjoins on the directors of every company the duty of preparing annually a balance‑sheet and profit and loss account and laying them before the general meeting of the company and section 131‑A dealing with the contents of the directors' report which should accompany the balance‑sheet enacts. "131‑A (1). The directors shall make out and attach to every balance‑sheet a report with respect to the state of the company's affairs, the amount, if any, which they recommend should 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 to be shown specifically in a subsequent balance‑sheet." Under this provision therefore while the directors "recommend" to the shareholders the amount to be paid by way of dividends, they are the authority competent to direct the allocation to reserves and they merely intimate to the shareholders what "they propose to do". In line with this, which merely embodied in statutory form the law as previously understood, Article 127 (t) of the assessee‑company's articles of association showed as one of the items of powers that the directors were expressly declared to have before recommending any dividend "to set aside out of the profits of the company such sums as they may think proper‑for such other purpose as the directors may, in their absolute discretion, think conducive to the interests of the company." What the annual report of the directors should contain was specified by Article 152 of the articles of association which proceeded on the distinction between the amount which the directors recommended to be paid out of the profits "by way of dividend or bonus to the shareholders" and the amount, if any, set aside by the directors "for the reserve fund, depreciation and renewal fund and the insurance fund or any other special fund." The power of allocation to a reserve has to be exercised, it should be remembered, before the directors recommended a dividend [see Article 127 (t)]. The learned counsel for the assessee contended that the power was exercised and the allocation was made by the directors at their meeting on 15th March 1946, and that that constituted the only valid and effective allocation to reserves. The learned counsel for the Department urged in effect that, even if the directors had the authority to set apart the sums in question, Rs. 9,00,000 and Rs. 2,00,000, that power was not exercised on 15th March 1946, but the directors left it to the shareholders to give affect to that allocation on 15th April 1946. Despite the wording in paragraph 2 of the report of the directors for 1945, which we have extracted above, it seems clear to us that there was a completed allocation of Rs. 11,00,000 on 15th March 1946, under resolution No. 2 of the board of directors. The board of directors had the authority, and it exercised it. The shareholders had not the authority to interfere with what the directors had already done.. Article 127 (t) of the articles of association read in the light of section 131‑A (1) gave an absolute discretion to the directors. If the shareholders purported to ratify on 15th April 1946, what the directors had already done on 15th March 1946, that did not affect the validity or the effectiveness of the allocation already ordered by the directors, an allocation which they were entitled to order and did order before they recommended‑ a dividend. Thus, the position is that factually a sum of Rs. 11,00,000 was set apart for the specified purposes before 1st April 1946, by the directors, who alone had the authority to do that. The material date for the second of the chargeable account ing periods with which we are concerned was 1st January 1947. The allocation of Rs. 5,25,000 out of the profits was made by the directors at their meeting held on 15th April 1947. They had the requisite authority to make that allocation, but they exercised it only after the material date 1st January 1947. On that ground the second of the questions referred to this Court has to be answered in the negative and against the assessee. The learned counsel for the assessee further contended that, whatever be the dates on which the directors allocated the profits in the manner referred to above these allocations became effective from the last date of the year of account in question, and it was so shown in the balance‑sheets for 1945 and 1946. He urged that there was a ‑valid and effective allocation to reserves, with refer ence to each of the chargeable accounting periods before the material date specified by section 2 (1) of the Act for each of them. The learned counsel relied on Commissioner of Income‑tax v. Aryodaya Ginning and Manufacturing Company Limited ((1957) 31 I T R 145) in support of this contention. In Commissioner of Income‑tax v. Aryodaya Ginning and Manufacturing Company Limited, the chargeable accounting period was from 1st January 1949, to 31st March 1949. The year of account ended on 31st December 1948. The balance‑sheet of the company as on 31st December 1948, showed an appropriation of' a sum of Rs. 11,08,000 to the reserve fund and a sum of Rs. 1,50,000 to the dividend reserve fund. That it was only the shareholders of the company that had the authority to effect the appropriation appears to have been accepted by both sides. In that case the meeting of the shareholders at which these appropriations were approved of was on 27th June 1949. The learned Judges held that the amounts transferred to the reserve fund must be taken into account in computing the capital of the company for the chargeable accounting period in question, 1st January to 31st March 1949. With all respect to, the learned Judges of the Bombay High Court, we confess our inability to accept that decision as a correct interpretation of the requirements of section 2 (1) (a) of the Act. What section 2 (1) (a) requires is an ascertainment of the computed capital on the first day of the chargeable accounting period in question. It is a factual ascertainment that is con templated and required. What was the factual position on the first day of the relevant chargeable accounting period that was the paid‑up capital on that date and what were the reserves on that date ; the two together made up the capital of the company within the meaning of section 2 (1). As pointed out by the Supreme Court in Commissioner of Income‑tax, Bombay City v. Century Spinning and Manufacturing Company Limited nothing is a reserve within the 7meaning of rule (2) (1) in Schedule II of the Act, which has not been appropriated as a reserve by a person having the requisite authority. The manner of the disposal of the available profits must be indicated on or before the material date, the first day of the chargeable account ing period in question, by a person with the requisite authority to do so. With reference to the second of the chargeable accounting periods with which we are concerned, from 1st January 1947, to 31st March 1947, the factual appropriation was made only after 1st January 1947, that is, on 15th April 1957. That appropriation, in our opinion, could not be related back to 31st December 1946, though the final balance‑sheet showed an appropriation effective from that date. Till the appropriations are actually made the funds of the company available to it constitute only a mass of undistributed profits and no portion of such undistributed profits can be called a reserve. That was made clear by the Supreme Court in Commissioner of Income‑tax, Bombay City v. Century Spinning and Manufacturing Company Limited. In Commissioner of Income‑tax v. Aryodaya Ginning and Manufacturing Company Limited the learned Chief Justice referred thus to the scope of the resolution of shareholders: "Therefore, the shareholders by passing a resolution on the 27th June 1949, did not decide that these amounts should constitute reserves as from that‑ date, but they accepted the recommendati6n of the directors that these amounts should constitute reserves of the company as on the 31st December 1948. At page 151 the learned Chief Justice observed: " . . . . the body of shareholders who are the persons with the requisite authority do not merely determine that a certain amount should constitute reserve, but they also determine and have the necessary authority for determining that that amount should constitute reserve as from a particular date, and in this case there is no doubt that the general meeting of the shareholders was considering the accounts for the year ended 31st December 1948, and passing resolutions with regard to those accounts." At page 152 the learned Chief Justice observed "In this case the profits were made at the end of 31st December 1948, and from 1st January 1949, the reserves were in existence and could be utilised for the working of the company as much as the capital. If that be so,, the mere fact that the shareholders passed a resolution at a later date cannot affect the merits of the question or the right of the assessee company to get the benefit of the abatement provided by the business profits tax." We venture to point out that the statement, that the reserves were in existence on 31st December 1948, may not be a quite correct statement of the factual position. What was in existence on 31st December 1948, in that case was a mass of undistributed profits which were available for distribution, no portion of which had been earmarked as a reserve on that date by any person having the requisite authority to do so. What, as we have pointed out earlier, rule 2 (1) requires is that the reserve should be factually in existence on the first day of the relevant chargeable accounting period. There can be no reserve until there is allocation in fact by a person having the requisite authority to order that allocation. If, in the case of the Aryodaya Company, it was the shareholders that had the requisite authority, the allocation could have become effective for the purpose of rule 2(1) only from the date on which they factually exercised that authority; and they do not appear to have had the further authority to give retrospective effect to that factual allocation. To sum up our conclusions on this portion of the case with reference to the chargeable accounting period 1st April 1946 to 31st December 1946, there was a valid and effective allocation of. a sum of Rs. 11,00,000 to reserves before the material date 1st April 1946. With reference to the second of the chargeable accounting periods 1st January 1947 to 31st March 1947, the sum of Rs. 5,25,000 was not validly and effectively allocated to any reserve by any one having authority to do so before the crucial date 1st January 1947. Mr. Rama Rao Sahib, learned counsel for the Department, next contended that the sum of Rs. 9,00,000 in regard to the first chargeable accounting period and Rs. 4,75,000 as regards the next, could not really be treated as "reserves", since they represent moneys set apart for the liquidation of tax liabilities already incurred, the argument being that as the sums would be expended during the course of that year and would not be available for being carried over to the next period, they were not "reserves" on which abatement could be claimed. Mr. Viswanatha Ayyar, the learned counsel for the assessee, raised a preliminary objection to permitting this contention, even if sound, being raised, since that was not the Department's case at any stage of the proceedings. In our judgment this objection is sound and ought to prevail. In the first place, the point as regards the nature of the fund set apart (as distinguished from the date when this was effectively done)‑‑not answering to the requisites of a "reserve" within rule 2 (1) of Schedule II was never raised by the Department at any stage. It is not a ground mentioned by the Income‑tax Officer; nor does it figure in the order Appellate Assistant Commissioner or of the Tribunal. No of it is indicated even in the statement of the case, not to of its forming part of the questions referred to us for Moreover, the point, even as formulated by Mr. Rama Rao Sahib, involves an investigation of matters of fact which has not been done, for the obvious reason that it was not thought of earlier. What we desire to indicate is that there is nothing in the record to show the exact tax liability of the company for the two "previous years", to permit of a computation of the amount which the company would have to pay out of the sums reserved, for it is conceded by the Revenue that at least the excess over the sum not spent out of the sum set apart would be a reserve. This is not therefore a case of a party seeking to support an order on purely legal grounds based on admitted or established facts‑as Mr. Rama Rao Sahib sought to urge. Since, however, the point has been argued in full we proceed to express our views on the matter. We need only mention at the outset that the objection can have real relevance only as regards the sum of Rs. 9,00,000 set apart for the chargeable accounting period 1st April 1946 to 31st December 1546, since we have held against the assessee on both the items in the succeeding accounting period. Our attention was not drawn to any reported case in which such a question was specifically decided, whether the provision for payment of taxes would constitute a reserve within the meaning of rule 2 (1). Apart from the positive rule of interpre tation laid down in Commissioner of Income‑tax, Bombay City v. Century Spinning and Manufacturing Company Limited bar the Supreme Court, there is one feature of that case to which we can refer, what, if we may do so with respect, is a negative aspect. At page 501 in the narrative of facts Ghulam Hasan, J., pointed out "The profits according to the profit and loss. account were Rs. 90,44,677 subject to the provisions for depreciation and taxation. After making provisions for these, the balance of Rs. 5,08,637 was carried to the balance‑sheet." Apparently the validity of the appropriation .for taxes as a reserve was not challenged, and their Lordships had to decide only the question, whether the balance of Rs. 5,08,637 which represented inappropriate profits, which were however not expended, constituted a reserve. In Commissioner of Income‑tax v. Aryodaya Ginning and Manafacluring ~ Company Limited a sum of Rs. 12,50,000 was set apart for payment of taxes. The claim of the assessee that it constituted "reserve" was negatived by the Tribunal, and the correctness of that decision does not appear to have been challeng ed by seeking any reference to the High Court on that point. As pointed out by the Supreme Court in Commissioner of Income‑tax Bombay City v. Century Spinning and Manufacturing Company Limited at page 503, "the term 'reserve' is not defined in the Act and we must resort to the ordinary natural meaning as understood in common parlance." Their Lordships then set out the dictionary meaning of the word "reserve". One such meaning was: "To set apart for some purpose or with some end in view ; to keep for some use." If that meaning were to prevail, it should be obvious that the sum of Rs. 9,00,000 was set apart for a specified purpose with a specified end in view, payment of taxes when they fell due. Reservation of a specified sum for a specified use, when the reservation has been validly made by a person having authority to do so, would appear to bring the sum so reserved within the meaning of the expression "reserve" in rule 2 (1). We should, however, make it clear that we are concerned in this case only with the question, whether the allocation of a specified sum out of the profits of the company to be kept back for utilisation towards the payment of tax is sufficient to make the sum so set apart a reserve within the meaning of rule 2 (1). We are not concerned with any of the other purposes for which the directors could have set apart a specified sum. As we pointed out earlier, if the test to apply is that indicated by the dictionary meaning of the word "reserve", those tests were satisfied. The sum of Rs. 9,00,000 was set apart. It was set apart for some purpose and was kept for some use, the purpose and use having been specified when the sum was allocated and "reserved", the payment of tax. In our opinion, the claim of the assessee that the sum of Rs. 9,00,000 constituted a reserve within the meaning of rule 2 (1) in Schedule II has to be upheld. The learned counsel for the Department referred to certain passages in The Principles of Auditing by F. R. M. de Paula in support of his contention, that the provision for taxation would not be a reserve. Judged by the principles of sound auditing that may not be a helpful test to apply, and we therefore refrain from examining in detail the passage cited to us. What is accepted as a sound principle of accountancy may not always justify a claim under the Income‑tax law, nor can it necessarily decide the issue, whether the claim made by the assessee in this case, that a specified sum constituted a reserve, should be negative. In our opinion the claim of the assessee that the sum of Rs. 9,00,000 constituted reserve within. the meaning of rule 2 (1) of Schedule II should even on the merits prevail. Our answer to the first of the questions referred to this Court is that the sum of Rs. 11,00,000 formed part of the company's capital within the meaning of rule 2 (1) of Schedule 11 read with section 2 (1) (a) of the Business Profits Tax Act in respect of the chargeable accounting period 1st April 1946 to 31st December 1946. We answer the second question in the negative and against the assessee. Since neither side has wholly succeeded in its contentions we make no order as to the costs of this reference. Reference answered accordingly.