Appeal No 3151958
Appeal by special leave from the judgment and order dated February 5 1957 of the Bombay High Court in ITR No 341956
372 R J Kolah and I N Shorff for the appellant
A N Kripal and D Gupta for the respondent
January 6
The Judgment of the court was delivered by KAPUR J
This is ail appeal against the judgment and order of the High Court of Judicature at Bombay in Income tax Reference No 34 of 1956
The appellant is a non resident Bank incorporated under the National Bank Act of the United States of America with its head office in that country and with branches all over the world including some branches in India
It was assessed under the Business Profits Tax Act Act XXI of 1947 hereinafter termed the  Act  in respect of the chargeable accounting periods 1 4 1946 to 24 12 1946 25 12 1946 to 24 12 1947 25 12 1947 to 23 12 1948 and 24 12 1948 to 31 3 1949 and the sole question for decision in this appeal is the meaning of the word  reserves  in R 21 of Schedule 2 of the Act and how the capital of the appellant during the above mentioned chargeable accounting periods has to be computed for the purpose of allowing the  abatement  under the Act
The appellant contended that in computing the amount for the purpose of abatement it was entitled to include what is termed in the United States  Undivided Profits  the contention being that this item falls within the word  reserves in R 21 of Schedule 11 of the Act which provides 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 purpose 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
 373 It is not necessary to give the details of all the years but it will be sufficient as an illustration if we were to confine ourselves to the  Undivided Profits  in the Balance Sheet as on December 31 1946 wherein the relevant entries were as follows  Capital   77500000 00 Surplus   15250000000 Undivided Profit   2953461421 The Report of the Directors dated January 14 1947 was as follows  At the year end Capital of the Bank remains at  77500000 surplus has increased to  152500000 by the transfer of Rs 10000000 from Undivided Profits
After this transfer Undivided Profits are  29534614 an increase of  240376 from a year ago
The Trust Company has Capital of  10000000 surplus of s 10000000 and Undivided Profits of  8097020
The two institutions thus show total capital funds that is Capital Surplus and Undivided Profits of  287631634 or  46 39 per share compared with  4460 per share at the end of 1945
 According to the Balance Sheet of 1948 capital funds since 1939 had increased from  169768 thousands to  320795 thousands in the year 1948 and there had been a progressive increase both in what is called  Surplus  as well as  Undivided Profits  the former increased from  62500 thousands to  182500 thousands and the latter from  19768 thousands to  50795 thousands
The question in this case is whether this large sum of money shown as  Undivided Profits  is a part of the Reserves or is equivalent to the unallocated amount carried forward at the end of a year of account in the balance of Profit  Loss Account as we know it
It was the sum of  2953461421 and similar sums for the other chargeable Accounting Periods which are the subject matter of controversy in this appeal
Both the Income tax Officer and the Appellate Assistant Commissioner excluded these amounts in determining the capital of the Bank under R 21 of Schedule II on the ground that they were not a part of the reserves of the Bank
374 The appellant took an appeal to the Income tax Appellate Tribunal which was dismissed on the ground that  Undivided Profits  meant nothing more than the  Balance of the profits and loss account and that no distinction could be drawn merely because in the nomenclature used in the United States the amount was shown as  Undivided Profits and not balance of the profit and loss account
At the instance of the appellant the following question of law was referred to the High Court
 Whether on the facts and in the circumstances of the case I Undivided Profits  of  2953461421 shown in the condensed statements of conditions as of December 31 1946 can be treated as reserves and added to the capital as required by rule 21 of Schedule II to the Business Profits Tax Act for the chargeable accounting period 25 12 1946 to 24 12 1947 In its order the Tribunal said that the Treasury Rules in United States divided capital account into four different heads Capital Reserve Surplus and the Undivided Profits
The reserves are really reserves for liabilities including the reserves for dividends
 The general reserves as shown by the balance sheet in India is equivalent to the Surplus
The undivided profits is equivalent to the balance of profit and loss account
 In the statement of the Case submitted to the High Court the Appellate Tribunal stated that the question whether the Undivided Profits meant the same thing as balance of the profit and loss account was a question of fact and it did not matter what name was given to it
But this was the very question which was referred to the High Court
The High Court after referring to the Directors  Report to the shareholders held that the Undivided Profit of  2953461421 did not constitute  reserves  because no direction had been given in regard to it it had never been transferred to any reserve and had never been earmarked for any particular purpose and that the only act of volition on the part of the Directors of the Bank was the transfer of 10 million 375 dollars to the Surplus
In its judgment the High Court said  It is true that these large amounts of Un divided Profits remain with the Bank that the Bank uses them that business is carried on with the help of those funds and that they are as much capital of the Bank as capital in the strict sense of the term  The High Court however held that they did not satisfy the test laid down by the Supreme Court in Century Spinning  Manufacturing Co Ltd vs CIT Bombay 1 as the amount was not transferred to any reserve and there being no act of volition on the part of the Directors this could not be regarded as Reserve
The correctness of this view is challenged before us
The Directors  report dated January 14 1947 shows that the surplus increased as a result of the allocation made by the Directors by 10 million Dollars which was taken from Undivided Profits and the Undivided Profits themselves increased to 2953461421 which was an increase of 240376 in the year 1946 and therefore the Capital Funds of the company which included Capital Surplus and Undivided Profits along with similar items from the Trust Company had increased considerably which was reflected in per share increase ie 4460 per share at the end of 1945 to 4639 per share at the end of 1946 thus showing that it was the result of an act of the Directors that Surplus was increased and a particular sum was left in the Undivided Profits
It was contended that no sum could be treated as Reserves  unless the Directors recommended it to be so allocated and it was so adopted by the shareholders
But this argument ignores the evidence placed by the appellant
Under the Treasury Rules of the United States of America containing  Instructions for Preparation of Reports of Condition by National Banking Associations  certain sums had to be specifically allocated under section 5211 of the revised Statute of the United States Title Items 25 to 28 according to these instructions deal 1  376 with Capital Account
Item 26 deals with Surplus  and item 27 with Undivided Profits  and item 28 with  Reserves  and retirement account for preferred stock
The following Reserves come under item 28 a
Reserve for dividends payable in Common stock
b Reserves for other undeclared dividends
c Retirement account forpreferred stock
d Reserves for contingencies etc
Item 29 was as follows  Total capital accounts 
This item is the sum of items 25 to 28 inclusive
Along with this the appellant has placed a copy of the letter from the Deputy Controller of Currency Washington the relevant portion of which is as follows   In connection with this matter we wish to assure you that your position as stated is in complete accord with that of the Office of the Comptroller of the Currency
In the United States the Undivided Profits  as reflected in the accounting of a bank actually represents a part of its capital funds
All of the other bank supervisory agencies in the United States consider the Undivided Profits  of a bank as a part of its capital funds
In any calculation for the purpose of determining the adequacy of capital in a commercial bank in the United States the supervisory authorities include Undivided Profits  as an integral part of the capital structure as it would not be possible otherwise to make an accurate computation
When losses occur in banks it is the usual practice in many banks to charge them against the Undivided Profits  account which by any reasoning would be inappropriate if the account were regarded as  Undistributed Profits 
In commercial banks in the United States it is not customary to maintain any account that could be regarded specifically as Undistributed Profits  in the same
sense as applied to similar accounts in the other corporations in India
The term Undivided Profits  simply follows a bank accounting nomenclature used ill the United States to 377 designate profits set aside after provisions for expenses and taxes dividends and reserves for continuous future use in the business of the bank  and it bears a close if not identical relationship to the Earned Surplus Account of an industrial corporation
Balance sheets of three other banks of the United States relied on by the appellant show that Capital Fund comprises three kinds of funds ie Capital Surplus and Undivided Profits
The documents placed on the record show that these three different kinds of funds put together make up what is called  Capital Fund 
The creation and maintenance of the item known as Undivided Profits is a requirement of the Treasury Rules which are made under the Statute and therefore it cannot be said that the amount of Undivided Profits in the Balance Sheet was not allocated as a result of either a resolution of the Directors accepted by the shareholders or on account of the requirements of the law
The  Undivided Profits  have to be employed in the manner indicated by the letter of the Deputy Controller of Currency
They are set up for expenses taxes dividends and reserves for continuous use in the business of the Bank and are a part of the capital funds and an integral part of the capital structure and without it it would not be possible to make an accurate computation
The reason for the existence of this fund as shown by that letter is that when there are losses they can be charged against Undivid ed Profits  which expression means profits set apart after provision for expenses and taxes etc
for continuous use in the business of the Bank
There is a difference between the system of accounting of Banking Companies in India and the United States the failure to appreciate this difference has led the Appellate Tribunal as well as the High Court to arrive at an erroneous conclusion
In India at the end of an 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 year In the system of accounting in the 48 378 US 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 credited 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 very 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
The nature of  Undivided Profits was considered by the Supreme Court of America in Fidelity Title and Trust Co vs United States 1
In that case a suit was brought by the Fedelity Co to recover the tax assessed on its whole capital and undivided profits under section 2 of the Spanish War Revenue Act
In the Supreme Court it was contended by the company that the terms Capital  Surplus  and  Undivided Profits  have a precise and definite meaning in the business of banking and that Undivided Profits are not surplus and cannot therefore be taxed as  Surplus 
The Government on the other hand contended that the undivided profits were taxable as being a part of Capital or Surplus
The Court held that  Undivided Profits 
were taxable as being a part of the Capital employed
Mr Justice Brandeis delivering the opinion of the Court said at p 955  The Act declares that in estimating capital surplus shall be included  and that the annual tax shall in all cases be computed on the basis of the capital and surplus for the preceding fisical year        As it is the use or employment of capital in banking not mere possession thereof by the banker which determines the amount of tax the fact that a portion of the capital so used or employed is 1   379 designated undivided profits  is of no legal signi ficance As to what the word  Reserves  as used in the Business Profits Tax Act connotes was considered by this Court in the Commissioner of Income tax vs Century Spinning  Manufacturing Co Ltd 1
It was held that the true nature and character of a sum disputed as reserve was to be determined with reference to the substance of the matter
The amount in dispute in that case was the profits after the deduction of depreciation and tax which amount was carried to the Balance Sheet and was later recommended by the Directors to be appropriated mainly to dividends and balance to be carried forward to the next year s account
Thus on the crucial date ie April 1 1946 from which the Chargeable Accounting Period began the sum in dispute had not been declared as reserve on the other hand the Directors had earmarked it for distribution as dividend and it remained as a mass of undistributed profits available for distribution
At page 209 Ghulam Hassan J said 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     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 dividend to the shareholders but kept back by the directors for any purpose to which it may be put in future     Applying this test to the disputed sum it cannot be said that the amount is not Reserve within the meaning of the Rules
As is shown by the instruction under section 5211 of the Revised Statute of the United States and the letter of the Deputy Controller referred to above the appellant bank was required to keep a certain sum of money under the head  Undivided Profits  and that is an integral part of the capital 1  380 structure
Under these circumstances it would be erroneous not to treat the amount of  Undivided Profits  as a part of the capital fund
In our opinion therefore the amount designated as Undivided Profits  is a part of the reserves and has to be taken into account when computing the capital and reserves within R 21 of Schedule 11 of the Act
The question which was referred by the Tribunal should have been decided in the affirmative and in favour of the appellant and the amount should have been added to the capital as allowed by R 21 for the Chargeable Accounting Periods
In the result the appeal is allowed
The appellant will have its costs in this Court and in the High Court
Appeal allowed


Summary:
By a deed dated March 5 1951 the appellant made a declaration of trust in favour of hiswife as follows I hereby declare that I hold 244 sharesupon trust to pay the income thereof to my wifefor a period of seven years from the date hereof or her death whichever event may be earlier and I hereby declare that this trust shall not be revocable
In the year of account 1951 a sum of Rs 30404 was received as dividend income on those shares and the appellant claimed before the income tax authorities that this sum was not liable to be included in his total income in view of the third proviso to section 161c of the Indian Income tax Act 1922 but this claim was rejected on the ground that the case was covered either by section 163aiii or by section 163b of the Act
The appellant s contention was that under the deed of trust there was no transfer of assets either to the wife or to any person for the benefit of the wife but merely a creation of a trust in respect of the shares the dividends from which were payable to the wife that even if it be held that there was such a transfer it was for adequate consideration being for love and affection which was a good consideration and that thus section 163aiii or section 163b was not applicable
Held that on a true construction of the deed dated March 15 1951 there was a transfer of the shares by the husband to himself as a trustee for the benefit of the wife and that even though the husband was the same individual in his capacity as a trustee he must be regarded as a person distinct from the transferor
Held further that the words adequate consideration in section 163 of the Indian Income tax Act 1922 denoted considera tion other than mere love and affection which in the case of a wife may be presumed
Accordingly the present case fell within section 163b of the Act and not within the third proviso to section 16ic
Provat Kumar Mitter vs Commissioner of Income tax   distinguished