Civil Appeal No 1665 of 1974 From the Judgment and order dated 2891973 of the Allahabad High Court in IT Reference No 195 of 1971
With Civil Appeal No 145 of 1976
Dalip Singh KC Dua and Miss A Subhashini for the Appellant
Harish Salve KJ John Ranjit Kumar and BP Singh for the Respondent
The Judgment of the Court was delivered by SABYASACHI MUKHARJI J
These two appeals were heard together
Civil Appeal No 1665 of 1974 arises from the decision of the High Court of Allahabad in Income Tax Reference No 195 of 1971
The assessee Elgin Mills Ltd at the relevant time was a public limited company engaged in the business of manufacture of textile goods
The assessment year involved is the year 1964 65 of which the relevant previous year ended on 30th September 1963
For the purposes of assessment under the provisions of Companies Profits Surtax Act 1964 a dispute arose between the assessee and the revenue with regard to the computation of Standard deductions
The company claimed that the following amounts should be treated as 411 reserves for the purposes of computation of its capital a Investment Reserve Rs8500000 b Rehabilitation reserve Rs4000000 c Forfeited Dividend reserve Rs96374 The Income tax Officer did not include any of the said reserves  in the capital of the assessee company on the basis that these did not represent reserve in the real sense
On appeal the Appellate Assistant Commissioner held that the Rehabilitation reserve and Forfeited Dividends reserve represented reserves but the investment reserve account did not constitute real reserve
Both the assessee as well as the revenue went up in appeal before the Tribunal
The Tribunal disposed of these appeals by a similar order along with two similar appeals relating to the assessment year 1963 64 which arose out of proceedings under the 
The Tribunal held that all the three accounts represented reserves for the purposes of assessment under the 
The Tribunal was further of the view that all the three represented reserves for the purposes of assessment under the and as the principle involved was the same as under the Companies Profits Surtax Act 1964 the Tribunal held that the accounts in question represented reserves under the latter Act also
At the instance of the Commissioner reference was made to the High Court for the assessment year 1964 65 on the following questions 1
Whether on the facts and in the circumstances of the case the tribunal was right in arriving at its decision by applying the principles laid down in the second schedule to the  instead of the provisions of the second Schedule to the Companies Profits Surtax Act 1964 for computation of capital of the assessee company for the assessment year 1964 65 2
Whether on the facts and in the circumstance of the case the tribunal was right in holding that a Investment Reserve b Rehabilitation reserve c Forfeited Dividend Reserve were includible in the capital computation of the company in accordance with the second schedule to the Companies Profits surtax Act 1964
 412 The High Court noted that in the connected reference No 196 of 1971 Commissioner of Income tax vs Elgin Mills Company Ltd decision dated 19th July 1973 arising out of proceedings under the  it had already held that these accounts in question constituted reserve in the real sense and as such should be taken into consideration in determining the standard deductions under section 92 of the Act 1963
It was not disputed before the High Court that if the present reference had been under the  the accounts in question would have to be held as reserves by the High Court in view of its previous judgment
But it was contended that the provisions of the Companies Profits Surtax Act 1964 were different from the provisions of the Super Profit Tax Act 1963
The High Court did not accept this contention
The High Court was of the view that under both the Acts charging sections section 4 were identically worded except that the expression standard deduction in had been replaced by the expression statutory deductions in the Companies Profits Surtax Act 1964
Under both Acts these deductions had to be computed with reference to the capital employed in the assessee company
Under both the Acts reserves of the company were to be treated as its capital and the only difference was in the second schedule to the  an explanation had been added
The said explanation was to the following effect For the removal of doubts it is hereby declared that any amount standing to the credit of any account in the books of a company as on the first day of the previous year relevant to the assessment year which is of the nature of item 5 or item 6 or item 7 under the heading RESERVES AND SURPLUS or of any item under the heading CURRENT LIABILITIES AND PROVISIONS in the column relating to Liabilities in the Form Balance Sheet given in of Schedule VI to the I of 1956 shall not be regarded as a reserve for the purposes of computation of the capital of a company under the provision of this schedule
 This explanation the High Court noted merely clarified what was implicit in the Super Profit Tax Act 1963
Item No S in the prescribed Balance Sheet under the is Surplus  ie Balance in profit and loss account after providing for proposed alloca 413 tions namely Dividend Bonus or Reserves
Item No 6 was Proposed additions to reserves and item No 7 was Sinking Funds
The Accounts mentioned in the explanation would not form a reserve for the purposes of the computation of capital of a company
In any case the High Court was of the view that none of the accounts in dispute fell under the heading current liabilities
It was contended before the High Court on behalf of the revenue that any amount credited to those accounts during the relevant previous year would fall in item No 6 viz proposed additions to reserves
The High Court found that there were no additions to those funds during the relevant previous year inasmuch as the amount standing in those accounts were being brought forward from year to year
In those circumstances the Tribunal was right in deciding the question with regard to the admissibility of the three accounts in question on the principle application to 
This Court in Vazir Sultan Tobacco Co Ltd vs Commissioner of Income Tax held that the expression reserve 
in and the Companies Profits Surtax Act 1964 are in pari materia
On merits it was agreed that the points were covered by the previous decision of the High Court in the case of Commissioner of Income tax Kanpur vs British India Corporation P Ltd Accordingly the High Court answered both the questions in the affirmative and in favour of the assessee
This appeal arises out of the said decision of the High Court
In Commissioner of Income tax Kanpur vs British India Corporation P Ltd supra the High Court noted the distinction between provision  and reserves  and observed that when an amount was set apart for a future liability it was called a reserve and when it was set apart to meet an existing liability it was called a provision
The High Court was of the view that the Tribunal in that case was right in holding that capital reserve stocks and stores reserves bad and doubtful debts reserves obsolescence reserve loans and insurance reserves and investment reserves were to be included in the computation of capital
The Tribunal was not right in including according to the High Court forfeited money reserve as the assessee had been transferring to this account dividends which had not been collected by the share holders after they had been declared and as and when the shareholders made a claim made payments and debited the same to the account
The High Court therefore was of the view that this account represented a provision in respect of an existing liability
The High Court in Income Tax Reference No 196 of 1971 had to 414 deal with investment reserve account rehabilitation reserve account capital reserve account and depreciation reserve account and held that these were reserves but the account maintained as dividend account did not represent reserve
The High Court in its judgment noted that on the 19th July 1973 relying on other judgment in Income Tax Reference No 200 of 1917 Commissioner of Income Tax vs The Saran Engineering Co Ltd had answered the question by saying that the aforesaid items were re serves
This is the subject matter of civil appeal No 1599 of 1974 which will also be disposed of by another judgment of this Court
Civil Appeal No 1665 of 1974 and Civil Appeal No 145 of 1976 which arose out of the Income Tax Reference No 196 of 1971 have been heard together and are being disposed of by this judgment
In this connection it would be desirable to dispose of Civil Appeal No 145 of 1976 separately first
It was submitted that the assessee had shown capital of Rs26379218 which included the aforesaid reserves including investment reserves rehabilitation reserve capital reserve depreciation reserve and forfeited dividends
The submission on behalf of the revenue by Sree Dalip Singh was that the amount of Rs85 lakhs in the relevant year as investment reserve was set apart by the assessee company to meet the liabilities of its Bombay Sub sidiaries Ms Madhav Mills Ltd and Calico Processors Ltd which were known to the assessee on the date of the balance sheet
The Directors  report according to the revenue left no room for doubt that these were anticipated losses of the assessee company in the form of the investments made in its Bombay subsidiaries known at the date of the balance sheet
These were liabilities according to Sree Singh actually staring in the face of the assessee company when it prepared the balance sheet
The Tribunal had held that it was a reserve because it was formed by transfer of the amount from capitalGeneral reserve
This according to the revenue could not be accepted
Revenue submitted that it was a common ground that originally the amount was set apart out of the undistributed mass of profits and therefore the moment it was taken out of the capital or general reserve it ceased to be a capital or general reserve and but for its being set apart to meet the liabilities of its subsidiaries it had again gone back and formed part of the undistributed mass of profits and thereby assumed its original character
It was submitted that the reserve in order that it might be so called in the real sense of the term must come out of the profits of the 415 company
But if reserves were constituted out of assets which were sold A or by any other means it would be difficult to term the amounts shown as reserve
It was submitted that the investments by the assessee company in the Bombay subsidiaries were in the nature of bad and doubtful debts
Therefore these were dead losses of the assessee company as the holding company and these amounts were ultimately bound to be writ ten off and according to the revenue s submission the substance of the matter clearly was that the amount of RS85 lakhs though shown as a reserve was in fact a provision to meet the anticipated losses or bad and doubtful debts in the shape of investments in the two subsidiaries aforesaid which were shown at the date of the balance sheet
For the assessee Sree Salve drew our attention to the distinction between reserve and provision which has been discussed in the decision of this Court in Metal Box Co Ltd vs Their Workmen at 67 68
According to the revenue the nature and object of the subsidiary companies have to be kept in view and the practical result revenue contended before us was that the shareholders of the holding company whose share capital had been employed for the floatation of the subsidiary companies had not only no power to control the dealings of the subsidiary companies but in fact had no knowledge of nor any right to the knowledge of or dealings of the subsidiary companies
The expressions Provision  and Reserve  are defined in Schedule VI Part III to the 
In the decision of this Court in Vazir Sultan s case supra it has been held that a provision was meant to provide for any known liability and the substance of the matter had to be kept in view
It was further submitted by Sree Singh that the depreciation reserve could not be considered to be reserve in the real sense at all
Forfeited dividends reserve of RS 108771 had to be a provision
On the other hand on behalf of the revenue it was submitted that in order to constitute reserve there must be an appropriation of profits current or accumulated and not a charge against the profits for the year
The conduct must bear out the intention to create a reserve
It must not be to set apart to meet any known liability a liability known but existing on the date of the balance sheet
The explanation reserve  has been defined in the text books of Accountancy which has been noted by this Court
It was urged that it could not be disputed 416 that reserve might be general or specific reserve what was required was that amount should be kept aprat for one or the other purpose either general or specific
The distinction between provision and reserve must be found out bearing in mind main features of the reserve
These are 1 It must be an appropriation of profits current or accumulated and not a charge against the profits for the year
2 The conduct of the parties must bear out that intention
3 It must not be to set apart to meet any known liability a liability known to exist on the date of the balance sheet
Reference in this connection may be made to the observations of this Court in Vazir Sultan s case supra at pages 569 70
The Calcutta High Court in Commissioner of Income Tax vs Eyre Smelting Private Ltd  noted the characteristics of provisions  as well as reserves 
It held inter alia that provisions were made against anticipated losses and contingencies it held further that an amount set aside of the profits designed to meet a contingency or liability or commitment or diminution in the value of the assets known to exist would be a reserve and an amount set aside to provide for a known liability to which the amount cannot be determined with substantial accuracy would be a provision
The said High Court differed from the decision of the Allahabad High Court in British India Corporation P Ltd supra in respect of bad and doubtful debts  Whether in respect of bad and doubtful debts the account could be treated as reserve or provision would depend upon the facts and circumstances of the case
The distinction between provision  and reserve  has been clarified by this Court in Metal Box Company of India Ltd vs Their Workmen supra at pages 67 68 which states as follows The next question is whether the amount so provided is a provision or a reserve
The distinction between a provision and a reserve is in commercial accountancy fairly well known
Provisions made against anticipated losses and contingencies are charges against profits and therefore to be taken into account against gross receipts in the P  L account and the balance sheet
On the other hand reserves are appropriations of profits the assets by which they are represented being retained to form part of the capital employed in the business
Provisions are usually shown in the balance sheet by way of deductions from the assets in respect of which they are made whereas general reserves and reserve funds are shown as part of the proprietor s interest 417 see Spicer and Pegler s Book keeping and Accounts 15th A Edition page 42
An amount set aside out of profits and other surpluses not designed to meet a liability contingency commitment or diminution in value of assets known to exist at the date of the balance sheet is a reserve but an amount set aside out of profits and other surpluses to pro vide for any known liability of which the amount cannot be determined with substantial accuracy is a provision see William Pickles Accountancy second edition p 192  clause 7 Schedule VI to the  which defines provision and reserve
 This Court in Commissioner of Income Tax Central Calcutta vs Standard Vaccum oil Co at 698 observed that the ordinary meaning of the expression reserve was something specifically kept apart for further use or for specific occasion
The observations made therein will have to be understood in the light of the subsequent decisions of this Court in Metal Box supra and Vazir Sultan supra
This Court in Vazir Sultan Tobacco Co Ltd etc
vs Commissioner of Income tax etc
supra considered the expression reserve  in the and Companies Profit Surtax Act 1964
It is not necessary to set out all the conclusions of this Court
Our attention was drawn to Datta s on the Company Law Third Edition at page 42 1
Reserves consist of appropriations from profits and other surplus and retained for future use
This however does not include any amount which had been kept to meet any liability or diminution in value of assets known to exist as on the date of the balance sheet
The essence and substance of the matter has to be kept in view
As reiterated before the distinction between provision  and reserve  is while the provision  is a charge of profits which are taken into account in the gross receipt of Profits  Loss Account reserve  is an appropriation of profit to provide for the asset which is represented
Keeping these tests and the facts of these appeals in mind we must hold that the conclusion of the High Court in Civil Appeal No 1665 of 1974 holding that the investment reserve and rehabilitation reserve were reserves and were entitled to be treated so under the relevant Act is right
But in the facts of the case the High Court was 418 not right in holding that the forfeited dividend reserve was reserve and question No 2 also in the affirmative
It should have followed in this respect its previous decision in respect of forfeited dividend reserve in Commissioner of Income Tax vs British India Corporation supra
The appeal therefore fails except on the point of Forfeited Dividend Reserve In Civil Appeal No 145 of 1976 we are concerned with five items as mentioned ie investment reserve rehabilitation reserve capital reserve depreciation reserve and forfeited dividends and in view of the facts found we are of the opinion that first four items constituted reserves and were entitled to be treated as such under the Act and the forfeited dividends did not represent reserve
This appeal accordingly fails in view of the facts found by Tribunal and reiterated by the High Court and the principles applicable as mentioned hereinbefore
The High Court in its order had excluded Forfeited dividend account from the reserve
The High Court was right in so doing
In the facts and circumstances of the case the parties will pay and bear their own costs in both the appeals
CA 166574 allowed in part
MLA CA 14576 dismissed


Summary:
In Civil Appeal No 1665 of 1974 a dispute arose between the respondent assessee and the Revenue with regard to the computation of standard deductions under the provision of Companies Profits Surtax Act 1964
The respondent assessee claimed that the three amounts in respect of three accounts namely a investment reserve b rehabilitation reserve and c forfeited dividend reserve should be treated as reserves for the purposes of computation of its capital for the assessment year 1964 65 of which the relevant previous year ended on 30th Sept 1963
The Income tax officer did not include any of the said reserves in the capital of the respondent company on the basis that these did not represent reserve in the real sense
The matter ultimately went before the Tribunal
It held i that all the three accounts represented reserves for the purposes of assessment under the and as the principle involved was the same as under the Companies Profits Surtax Act 1964 the accounts in question represented reserves under the latter Act also
The High Court also relying on its earlier decision in Commissioner of Income tax Kanpur vs British India Corporation P Ltd 92 TIRE 38 affirmed the view taken by the Tribunal and held i that under both the Acts charging sections section 4 were identically worded except that expressionStandard Deduction in had been replaced by the expression statutory deductions in Companies Profits Surtax Act 1964 ii that under both Acts these deductions had to be computed with reference to the capital employed in the assessee s Companies and iii that under both the Acts reserves of the company were to be treated as its capital and the only difference was in the 409 Second Schedule to the Companies Profits Surtax Act 1964 where an A explanation had been added and this explanation merely clarified what was implicit in the Super Profit Tax Act 1963
In CA No 145 of 1976 the assessee respondent had shown capital of Rs26379218 which included inter alia investment reserve rehabilitation reserve capital reserve depreciation reserve and forfeited dividends
The High Court held that the first four items constituted reserves and the forfeited dividends account did not represent reserve
Dismissing the CA No 145 of 1976 and allowing CA No 1665 of 1974 in part  HELD 11 The conclusion of the High Court in CA 1665 of 1974 holding that the investment reserve and rehabilitation reserve were reserves and were entitled to be treated so under the relevant Act is right
But in the facts of the case the High Court was not right in holding that the forfeited dividend reserve was reserve
However in CA No 145 of 1976 the Tribunal and the High Court had rightly excluded forfeited dividend account from the reserve
417G H 418D 21 The Supreme Court in Vazir Sultan Tobacco Co Ltd vs Commissioner of Income Tax 1981 132 TIRE 559 held that the expression reserve in and the Companies Profits Surtax Act 1964 are in pari materia
413C D 22 The distinction between provision and reserve is while the provision is a charge of profits which are taken into account in the gross receipt of Profits and Loss Account reserve is an appropriation of profit to provide for the asset which it represented
Reserve might be general or specific reserve what is required is that the amount should be kept apart for one or the other purpose either general or specific
The distinction between provision and reserve must be found out bearing in mind the main features of the reserve
These are i it must be an appropriation of profits current or accumulated and not a charge against the profits for the year ii the conduct of the parties must bear out that intention iii it must not be to set apart to meet any known liability a liability known to exist on the date of the balancesheet
416A C In the instant cases keeping in view the aforesaid tests invest 410 ment reserve rehabilitation reserve capital reserve and depreciation reserve constituted reserves and are entitled to be treated as such under Companies Profits Surtax Act 1964
The forefeited dividends do not represent reserve
417G H 418A B Vazir Sultan Tobacco Co Ltd vs Commissioner of Income Tax  981  Metal Box Co Ltd vs Their Workmen at 67 68 and Commissioner of Income Tax Central Calcutta vs Standard Vaccum oil Co at 698 relied upon
Commissioner of Income tax Kanpur vs British India Corporation P Ltd approved
Commissioner of Income Tax vs Eyre Smelting Private Ltd referred to