P L D 1957 (W (PLP)

KAIKAUS, J.‑

This is a reference under section 66 (1) of the Income‑tax Act and concerns the liability of the assessee, a limited company, to pay tax under the Business Profits Tax Act for two chargeable accounting periods, (1) from the 1st of April 1946 to the 30th of June 1946, and (2) from the 1st of July 1946 to the 30th of June 1947. In order to appreciate the question of law that is involved it is necessary to refer to the salient provisions of the Business Profits Tax Act. The Business Profits Tax Act came into force on the 12th of April 1947, but it was given effect from the 1st of April 1946. The object of the Act was to impose a further tax where more than normal profits had been earned. The Act regards profits which exceed six per cent. of the capital as excessive profits, and charges a tax only on such excess. According to section 4 of the Act, which is the charging section, tax is to be paid on the amount of "taxable profits" during any chargeable accounting period. "Taxable profits" are defined under section 2 (17) as the amount by which the profits during the chargeable accounting period exceed the "abatement" in respect of that period. "Abatement" is defined in section 2 (1) as meaning in relation to a company, six per cent. of the capital of the company on the first day of the chargeable accounting period. The capital of the company is to be determined in accordance with Schedule II to the Act. The relevant rule in the Schedule is rule 2 which runs:

"(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 Income‑tax Act, 1922, diminished by the cost to it of its investments or other property the income from which is not to be included in the profits, so far as that cost exceeds any debt for money borrowed by it. (2) In all other cases, the capital shall be the sum ascer tained in accordance with the first part of sub‑rule (1), diminished by the cost to the company of its investments so far as that cost exceeds any debt for money borrowed by it." In accordance with this rule, in order to determine the 'capital', such reserves of the company as existed on the first day of the chargeable accounting period are to be added to the paid‑up capital. The effect of these provisions is that in order to determine the business profits tax of a company, we have to determine first the amount of total profits and then deduct from this amount six per cent. of the capital (in its ordinary sense) as well as six per cent. of the amount of those reserves which are not excluded when income is computed for the purpose of income‑tax. The only question to be determined in the present case is whether certain amounts are to be regarded as reserves within the meaning of rule 2 of Schedule II. It is admitted that these amounts are subject to payment of income -tax. "Accounting period" is defined in section 2 (2) of the Act as the period which constitutes the 'previous year' for the purpose of income‑tax, and "chargeable accounting period" is defined in section 2 (4) as any accounting period between the 1st of April 1946 and the 31st of March 1953, with the proviso that if the accounting period falls partly within this term it becomes a chargeable accounting period. The accounts of the assessee are made up on the 30th of June every year and as a result the first chargeable accounting period for which the assessee became liable to pay business profits tax is the period from the 1st of April 1946 to the 30th of June 1946, and the second chargeable accounting period is the one from the 1st of July 1.946 to the 30th of June 1947. In order to determine what was the 'capital' of the assessee within the meaning of section 2 (1) of the Act (six per cent. of which will be "abatement") with respect to the first chargeable accounting period, the amount of its reserves on the 1st of April 1946 had to be determined. The con tention of the assessee before the Income‑tax Appellate Tribunal was that the whole of the undistributed profits lying with assessee on the 1st of April 1946 should be regarded as reserves and these undistributed profits consisted, according to the assessee, of two items :‑- (1) the whole of the undistributed balance of the profit and loss account of the year 1944‑45, and (2) three‑fourths of the net profits of the year 1945‑

46. The argument in respect of the second item was that three fourths of the profits of the whole year (from the 1st of July 1945 to the 30th of June 1946) should be deemed to be with the assessee on the expiry of nine months, that is, on the 1st of April 1946. The total net profits of the assessee (after deducting depreciation) for the year 1945‑46 were Rs. 1,28,73,213, The undistributed balance of the profit and loss account of the year 1944‑45 less dividends paid on it as on the 1st of April 1946, was 1,47,

697. Taking the whole of the last‑mentioned sum and adding to it three‑fourths of the first‑mentioned sum the total comes to Rs. 98,02,608 and the assessee claimed that this was a reserve within the meaning of rule 2 (1) of Schedule II to the Business Profits Tax Act. The alternative contention was that at least the undistributed balance of the balance of profit and loss account of the previous year should be regarded as a reserve because the company had already taken a decision with respect to it that it was not to be distri buted in that year. The questions of law which have been referred to us by the Income Tax Appellate Tribunal with respect to this period are :‑ "(1) Whether, in the circumstances of the case, the sum of Rs. 98,02,608 being the unappropriated balance on profit and loss account, as computed by the assessee, constitutes a reserve of the company as on the 1st April 1946, within the meaning of rule 2 (1) of Schedule II to the Business Profits Tax Act ? If the answer to the first question be in the negative. (2) Whether the unappropriated balance on profit and loss account as on the 30th June 1945, less dividends paid up to the 31st March 1946, constitutes a reserve of the company as on the 1st April 1946, within the meaning of rule 2 (1) of Schedule II to the Business Profits Tax Act ?" With respect to the second chargeable accounting period, the contention of the assessee was that on the 1st of July 1946, undistributed profits amounting to Rs. 1,30,20,910 were lying with the company and as they had not yet been distri buted as profits they should be regarded as a reserve. The Tribunal framed the following question:‑-- "Whether, in the circumstances of the case, the sum of Rs. 1,30,20,910 being the unappropriated balance on profit and loss account constitutes a "reserve" of the company as on 1st day of the relevant chargeable accounting period within the meaning of rule 2 (1) of Schedule II to the Business Profits Tax Act ?" We will take up first the question relating to the first chargeable accounting period. The contention of the assessee with respect to the first question hardly needs serious consideration. The first part of that contention is that out of the total profits earned in the year 1945‑46, three‑fourths should be regarded as having accrued on the 1st of April 1946. We do not see how there can be either an inference or a presumption that three‑fourth profits had been earned on that date. It may very well be that all profits were earned after the 1st of April 1946 though it may even be that the whole of the profits or perhaps more than the total profits (there may be loss in the period after the 1st of April 1946) had been earned by that date. In any case, the answer to this part of the argument is not very material for the answer to the second part of the contention, namely, that all profits lying with the company with respect to which no decision has as yet been taken by the company should be regarded as reserves, must be against the assessee. No authority has been cited by the learned counsel for the assessee for this extreme proposition and Commissioner of Income‑tax v. The Century Spg. and Mfg. Co, Ltd. ((1951) 20 I T R 260), the case on which he relies in support of the argument on the second question and to which case there is reference in more detail later in this judgment, goes against him. The word "reserve" can have no application to profits with respect to the application of which there is as yet neither proposal nor decision, whether the word be used in its ordinary sense or in its technical sense. We answer the first question in the negative. It is to be observed that the first question involves only the contention that mere existence of undistributed profits makes them a reserve. The peculiar position of the sum of Rs. 1,47,697, which was a part of the balance of the profit and loss account of the year 1944‑45 and which the assessee had decided not to distribute as dividend, is the subject matter of the second question. With respect to the second question the contention of the assessee is that if the company takes a decision as to distribution of profits and leaves a certain amount undistri buted, though the amount is not allocated to a particular reserve, the amount is a reserve within the meaning of rule 2 of Schedule II. Before proceeding with a discussion of this contention we will reproduce the provisions of the Companies Act which have a bearing on the question before us :‑ Section 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 shown specifically on the balance‑sheet or to a Reserve Fund, General Reserve or Reserve Account to be shown speci fically in a subsequent balance‑sheet. Regulation 97.--No dividends shall be paid otherwise than out of profits of the year or any other undistributed profits. Regulation 99.‑--The directors may, before recommending any dividend, set aside out of the profits of the company such sums as they think proper as a reserve or reserves which shall, at the discretion of the directors, be applicable for meeting contingencies, or for equalizing dividends, or for any other purpose to which the profits of the company may be properly applied, and pending such application may, at the like discretion, either be employed in the business of the company or be invested in such investments (other than shares of the company) as the directors may from time to time think fit. According to section 131‑A, the directors have to state the amount which they would carry to the reserves and have also to make recommendations as to the amount which is to be distributed as dividend. In practice, the directors allocate some amounts out of the profits to a number of special reserves like reserve for bad debts, reserve for depreciation, reserve for equalization of profits etc. and also to what is called "General Reserves", but even after alloca ting amounts to these reserves, a sum is generally left with the company which has neither been distributed as dividend nor is allocated to a particular reserve. That is what happened in the present case. The balance‑sheet of the assessee for the year 1945‑46 shows that out of the profits of the previous year a particular amount was set apart for dividends and certain sums were allocated to reserves, but some undistributed profits were still left with the company. It is these undis tributed pco4ts that are the subject matter of the second, question. Sometime between the 30th of June 1945, and the 1st of April 1946 the company had taken a decision as to the amount to be paid as dividend out of the profits for the year 1944‑

45. That 'is the assumption of the second question because it refers to the payment of dividends. Also this has not been denied before us during argument. As will appear from the contention of the assessee the question that falls for decision is: If the profits of a year be so applied that a part is distributed as dividend and out of the balance amounts are allocated to special and general reserves, but a sum be still left which is not distributed as dividend, will the last‑mentioned sum be a reserve ? In other words, does the mere withholding of a sum from distribution as dividend constitute it a reserve or is it necessary in order to constitute it a reserve that it should be so named? The word 'reserve' is not defined in any statute applicable to Pakistan or pre-partition India. It is urged for the assessee that when the shareholders decided not to distribute this sum as dividend they reserved it in the ordinary dictionary meaning of the word 'reserve'. 'Reserve', it is contended, means no more than this that its distribution as dividend has been withheld. That this is the ordinary grammatical sense of the word cannot be denied. It is claimed on behalf of the Income‑Tax Commissioner that in its technical sense 'reserve' cannot refer to an amount not so named and this seems to have been assumed in the judgment mentioned above which is relied upon by the assessee. We will presently show that it is a mistake to assume that according to books on accountancy the amount in dispute cannot be 'reserve' and that even in the technical sense an amount which the company decides not to distribute may be regarded as a 'reserve'. Assuming, however, that in its technical sense the word refers only to amounts expressly so named, we will consider which interpretation will be in consonance with reason, It is conceded by learned counsel for the Income‑Tax Commissioner that had this amount been named as a reserve, then, although the intention with which it was withheld remained the same, it would be a reserve within the meaning of rule 2 of Schedule

11. In this situation one naturally asks: will the legal effect be different if it is named as a reserve? Will the power, of the company to distribute it be affected if it is so named? If these questions be answered in the negative, if the power of the company with respect to the disposal of this amount be the same whether it is called a reserve or is simply left undetermined will it be reasonable to attribute to the legislature an intention that the liability to tax should depend on the use of a particular word ? It is conceded by learned counsel for the Income‑Tax Commissioner that there is nothing in the Companies Act attaching a particular legal result to the use of the name 'reserve'. On the other hand, Regulations 97 and 99, which have been quoted above, would show that all reserves are liable to distribution and are regarded simply as distributed profits. Regulation 99 makes them avail able for application to all purposes to which undistri buted profits may be applied. To interpret the word therefore in its technical sense would be to look not to the substance of an act but merely to the name by which it is called, and this, in the absence of strong reasons cannot be regarded as the intention of the legislature. Reserves can be created for any purpose, even for the purpose that they may be distributed in a subsequent year, which may be the very next year. If profits are withheld with the intention that they will be distributed in a subsequent year but are not given the name of a reserve, should the omission to use the word reserve make any difference to the liability of the company to tag ? Suppose in the present case the assessee had, instead of simply leaving this amount undistributed anti carrying it to the next year, said with respect to it "reserved for distribution in the next year". It is conceded that in that case this amount would have constituted a reserve within the meaning of rule 2 of Schedule II. We do not see why it should not be regarded as a reserve if in fact it is not distributed with that intention though the word 'reserve' is not used. Under the circumstances, we think it will tie proper to construe 'reserve' only in its ordinary grammatical) sense and not to confine it to cases where the word 'reserve' B is employed. Learned counsel for the assessee has relied upon Commissioner of Income‑tax v. The Century Spg. and Mfg Co., Ltd., in support of his contention that such undistributed profits are a reserve and that case does support him. The facts in that case, as they appear from the judgment (for in appeal against the judgment they were found to be different) were that out of the profits of the company a sum of Rs. 5,08,637 was not distributed and was simply carried over to the next year's account. Chagla, C. J. and Tendolkar, J. held that 'reserve' was to be interpreted in its ordinary sense and that this amount would constitute a reserve. Dealing with the argument that unless an amount was reserved for some specific purpose, it could not be called a reserve, Chagla, C.J., said :‑ "I do not see any reason at all why in order that a certain amount should be a reserve it should be appropriated for a specific purpose. It was open to the Directors to distribute the sum of Rs. 5,08,637 as dividends. They did not choose to do so and have kept back this amount. Therefore, by keeping back this amount they constituted it a reserve. 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. Therefore giving to the 'reserves' its plain natural meaning it is clear that the sum of Rs. 5,08,637 was kept in reserve by the company and not distributed as profits and subjected to taxation. Therefore, it satisfied all the requirements of rule". This judgment was no doubt set aside on appeal by the Supreme Court vide 6 S C R 203, but that was, at least to a great extent, because the High Court had misconceived the facts. The true facts as they emerge from the judgment of the Supreme Court were that the total profits of the assessee for the calendar year 1945, after deducting depreciation and taxes were Rs 5,08,

637. On the 28th of February 1946, the directors had recommended that the whole of this amount with the exception of Rs. 16,211‑6‑8 be distributed as dividend. This report came up for consideration in the general meeting of the shareholders on the 3rd of April 1946 and was accepted. The relevant date for determining‑ whether any ‑reserves existed was the 1st of April 1946. The Supreme Court pointed out that on the 1st of April 1946 nobody possessed of requisite authority had indicated the manner of disposal of this sum for it was only the shareholders who could take a decision with respect to it. On the other hand, on that date there was a recommendation by the directors that this sum should be distributed as profits. The observations of Chagla, C. J. : That it had been "Kept back" by the directors was therefore based on a misapprehension. The a Supreme Court agreed that the word 'reserve' was to be construed in its ordinary grammatical sense. They refused to declare the amount in dispute a 'reserve' on the ground that on the 1st of April 1946 a decision with respect to its disposal had riot been taken by the shareholders. The Supreme Court judgment too supports the assessee inasmuch as it interprets 'reserve' in its ordinary grammatical sense. In order to show that even in its technical sense the word reserve may include the amount in dispute we will just refer to Guide to Company Balance Sheets and Profit and Loss Accounts by Frank H. Jones 1951 Ed. Referring to the meaning of this expression, as it was in 1938, the learned author of this book says‑- "When the first edition of this book was published in 1938. the author strongly deplored the inadequacy of accounting nomenclature in this country which was unable to employ separate and distinct terms to denote (1) provisions made out of profits for specific purposes and (2) profits already earned which are set aside (i.e. reserved) for future use or for distribution. The expression 'reserve was loosely used to refer to either, and as they differ as widely as the proverbial chalk and cheese, the importance of designating each with a distinctive title was urged. It is satisfactory to record that since that time confusion has been almost entirely removed by several official pro nouncements and. the clarifications have now been clothed with statutory authority in the Act. The Act referred to is the Companies Act which was amended in 1948. Referring to the meaning of this word as it stood in 1951 the learned author says‑ "A reserve exists when a company has refrained from devoting the whole of its profits to dividends, and has retained a portion for future use. It consists of appropriations from profits and other surpluses which have been earned in the past, i.e. amounts which are not designed to meet any liability, contingency, commitment or diminution in value of assets known to exist as at the date of the balance sheet Reserves are accumulations of un drawn profits, invested either within or outside the business. They represent revenue earned in the past and kept available for use or disposal in the future. Reserves belong to the shareholders, and the modern method of presentation in the balance sheet is to `group' them with other shareholders' fund, i.e. issued capital, capital reserves, and any credit 'carry forward' from the profit and loss account. Conversely, any debit carried forward on profit and loss account should be shown within the same group by way of deduction. It is worthy of mention that there is neither any legal nor any fundamental difference between a reserve and a credit balance accumulated on the profit and loss account". The last sentence of this quotation particularly makes it clear that a reserve and a credit balance are placed on the same footing. We hold that all profits which a company decides to withhold from distribution as dividend, though such with holding be only for a year, are 'reserve' within the meaning of rule 2 (1) of Schedule‑II of the Business Profits Tax Act and we answer the second question in the affirmative. The question relating to the second chargeable accounting period already stands answered by what we have said above. On the 1st of July 1946, with respect to distribution of the profits of the company during the preceding year, no decision had as yet been taken. In order to constitute a reserve, there must be a conscious act by the company withholding, an amount. It cannot be said, therefore, that on the 1st oil July 1946, the profits of the preceding year constituted a reserve. We answer the question in the negative. A.H. Reference answered.