Appeal No 1695 of 1971
From the Judgment and Order dated 2 2 1970 of the Bombay High Court in IT Reference No 5463 V Rajagopal and AG Pudissery for the Appellant
ST Desai BBAhuja and RN Sachthey for the Respondent
UNTWALIA J This is an appeal by an assessee on grant of a certificate of fitness by the Bombay High Court under section 66A 2 of the Income tax Act 1922 hereinafter referred to as the 1922 Act
The assessee is an individual
We are concerned in this case with his assessment for the assessment year 1958 59 corresponding accounting year being 1st April 1957 to 31st March 1958
The Income tax Tribu nal made a composite order disposing of the assessee s 640 appeals in respect of two assessment years ie 1958 59 and 1959 60
The decision of the Tribunal was partly in favour of the assessee and partly in favour of the Revenue
In respect of the assessment year 1958 59 a reference under section 661 of the 1922 Act was made by the Tribunal to the High Court
Four questions were referred one at the instance of the Commissioner of Income tax and three at the instance of the assessee
The High Court by  its judgment under appeal which is reported in Commissioner of Income tax Central Bombay vs PK Badiani1 has answered almost all the questions
against the assessee
Hence this appeal
Mr V Rajgopal who had argued the case of the assessee before the High Court appeared before us in support of the appeal also
He could not and did not attack the decision of the High Court as respects questions 2 3 and 4
But he strenuously urged before us for reversal of the High Court judgment in regard to question No 1 which was re ferred at the instance of the Commissioner
If the assessee could succeed before us in getting an answer in his favour to the said question then substantially he would have succeeded in getting the whole of the relief
The first and the only question which falls for our examination in  this appeal was referred by the Tribunal to the High Court in the following terms 1 Whether the development rebate reserve created by the company by duly charging the amount to the profit and loss account and being allowable under the Act constituted accumulated profits  of the company within the meaning of section 26Ae of the Act We proceed to state the necessary facts for determina tion of the above question only
The assessee was a major shareholder although at the relevant time being a major or minor shareholder did not make any difference in law in the Sadhana Textile Mills Pvt Ltd which was indisputably a Company in which the public were not substantially interested within the meaning of Section 23A of the 1922 Act
The assessee was also the Managing Director of the said Private Limited Company
He had a mutual open and current account in the books of the Company the accounting year of which was the calendar year ie commencing from January and ending in December
The assessee in his accounting year 1957 58 had withdrawn con siderable amounts of money from the Company s account
The Income tax Officer  treated the withdrawals made by the assessee as advances or loans given by the Company to him and taxed the amount as dividend under section 26Ae of the 1922 Act
The Appellate Assistant Commissioner modi fied the figure of the deemed dividend calculated by the Income tax Officer and took the highest amount of advance made I 641 to the assessee by the Company at a particular point of time in the year in question as the amount of dividend taxable in the hands of the assessee
The said amount was within the total figure of accumulated profits in the hands of the Company at the relevant time ie 31st December 1956
It may just be stated here that according to the 1922 Act only the accumulated profits possessed by the company at the
end of the corresponding previous year had to be taken into account unlike the corresponding provision engrafted in section 222 of the Income tax Act 1961 hereinafter referred to as the 1961 Act read with Explanation II thereto
It was found that the aggregate amount of develop ment rebate allowed to the Company under section 102vi b was Rs 236470 
The said amount had been debited in the profit and loss account of the Company for the account ing year 1966 leaving a balance of Rs 6641 only in the profit and loss account
The Appellate Assistant Commis sioner of Income tax treated the entire sum of Rs 243111 as the amount of accumulated profits possessed by the Company
Finding the highest amount of advance to the assessee
at a particular point of time to be aggregating to Rs 18349370 he directed the addition of the said amount in the assessee s income under section 26Ae of the 1922 Act
The High Court has directed some modification in the calculation of the said amount while answering the other questions referred to it at the instance of the asses see and we need not go into their details
The main question for our determination in this appeal is whether the aggregate of the development rebates allowed to the Company under section 102vi b of the 1 922 Act could be treated as accumulated profits in the hands of the Company under section 26Ae
The Income tax Acts have undergone numerous changes from time to time and various amendments have been made both in the 1922Act as also in the 1961 Act
We shall do well to quote all the subclauses a to e of section 26A of the 1922 Act
They read as follows 26A dividend includes a any distribution by a company of accumulated profits whether capitalised or not if such distri bution entails the release by the company to its shareholders of all or any part of the assets of the company b any distribution by a company of deben tures debenture stock or deposit certificates in any form whether with or without interest to the extent to which the company possesses accumulated profits whether capitalised or not c any distribution made to the shareholders of a company on its liquidation to the extent to which the distribution is attributable to the accumulated profits of the company immediately before its liquidation whether capitalised or not 642 d any distribution by a company on the reduc tion of its capital to the extent to which the company possesses accumulated profits which arose after the end of the previous year ending next before the 1st day of April 1933 whether such accumulated profits have been capitalised or not e any payment by a company not being a company in which the public are substantially interested within the meaning of section 23A of any sum whether as representing a part of the assets of the company or otherwise by way of advance or loan to a shareholder or any payment by any such company On behalf or for the individual benefit of a shareholder to the extent to which the company in either case possesses accumulated profits Explanation The expression accumulated profits wherever it occurs in this clause shall not include capital gains arising before the 1st day of April 1946 or after the 31st day of March 1948 and before the 1st day of April 1956
 The expression accumulated profits occurring in clause e of section 6A or as a matter of that in any of the other clauses undoubtedly means profits in the commercial sense and not assessable or taxable profits liable to tax as income under the1922 Act
It is a well known concept of the taxation law that the term profits  in the various sections of the Income tax Acts have not got the same meaning
In the context sometimes it means the assessable profits and sometimes it means the commercial profits
In Palmer s Company Law Twenty First Edition at page 662 the distinc tion between profits divisible profits and profits avail able for dividend has been pointed out
At the said page occurs an oft quoted classical passage from the judgment of Fletcher Moulton LJ in Re Spanish Prospecting Co Ltd 1 which runs thus  Profits  implies a comparison between the state of a business at two specific dates usually separated by an interval of a year
The fundamen tal meaning is the amount of gain made by the business during the year
This can only be ascer tained by a comparison of the assets of the busi ness at the two dates 
If the total assets of the business at the two dates be compared the increase which they show at the later date as compared with the earlier date due allowance of course being made for any capital introduced into or taken out of the business in the meanwhile represents in strictness the profits of the busi ness during the period in question
 Bhagwati J has quoted the above passage with approval in the case of ED Sassoon  Company Ltd and others vs Com missioner of Income tax Bombay City
 2 Almost to the same effect was the view 1  98
2 at page 46
643 expressed by Mahajan J as he then was in the case of Commissioner of Income tax Bombay vs Ahmedbhai Umarbhai  Co Bombay1 In Commissioner of Income tax Bombay City vs Bipinchandra Maganlal  Co Ltd 2 Shah J as he then was delivering the judgment on behalf of the Court while interpreting the expression smallness of profits occur ring in section 23A of the 1922 Act said at page 296 A company normally distributes dividends out of its business profits and not out of its assessa ble income
There is no definable relation between the assessable income and the profits of a business concerned in a commercial sense
Computation of income for purposes of assessment of income tax is based on a variety of artificial rules and takes into account several fictional receipts deductions and allowances   
Smallness of the profit in section 23A has to be adjudged in the light of commercial principles and not in the light of total receipts actual or fictional
 The same view has been expressed by this Court in Gobald Motor Service P Ltd vs Commissioner of Income tax Ma dras3
We think that the term profits occurring in section 26Ae of the 1922 Act means profits in the com mercial sense that is to say the profits made by the Company in the real and true sense of the term
We may just give one example
Suppose the assessable profit of a company is Rs 100000 out of which the Company had to pay a tax under the Income tax Act say to the extent of Rs 30000 
Although payment of tax is not a sum deductible from the assessable profits of the Company in the commer cial sense the Company would be left with a sum of Rs 70000 only as profits
We may add that Mr Rajgopal could not and did not seriously dispute this proposition of law
The gravamen of the argument of the assessee has been that development rebate deductible from the assessable profits of the Company is also
a type of outgoing expendi ture or out of pocket cost which is deductible while ascertaining the profits of the Company in the commercial sense
Counsel submitted that it is in the nature of a depreciation allowance and is identical with initial depre ciation it should therefore be deducted from the commer cial profits of the Company as held by the Gujarat High Court in the case of Commissioner of Income tax Bombay North vs Viramgam Mills Co Ltd 4
This argument found favour with the Tribunal but was repelled by the High Court
The point is res integra and we have to examine the correct ness of the view expressed by the High Court
Depreciation allowance has been allowed to be deducted from the assessable profits of an assessee under section 102 vi of the 1922 Act corresponding to section 32 of the 1961 Act
It would appear from the report of the Taxation Enquiry Commission 1953 54 Vol
II as to what is the nature of the depreciation allowance vide Chapter V page 74
The normal depreciation provided in clause vi and the additional depreciation mentioned in clause vi a of section 102 of 1 18 ITR 472 at 502
2 41 ITR 290
3 4 43 ITR 270
644 the 1922 Act is permitted to be deducted from the written downvalue 
By and large the cost of replacements is allowed as deductions in lieu of depreciation in respect of certain assets
By the amendments made by the Income tax Amendment Act 1946
 the Finance Act 1955 and the Finance Act 1956 certain initial depreciation was allowed in re spect of buildings newly erected or the machinery and plant newly installed
Obviously it was by way of an incentive for the new structures or the new installations
The amount of initial depreciation was not deductible in deter mining the written down value  although under proviso c it was to be taken into account in the aggregate of all allowances so as not to permit them to exceed the maximum limit provided therein
Development rebate was provided in clause vi b with effect from 1st April 1955 by the Fi nance Act of 1955
There was an over lapping period of about two years in relation to the allowance of initial depreciation or the development rebate
But as provided for in clause vi an assessee could not have  had both even in regard to that period
Although initial depreciation and development rebate were not identical as they differed in some material particulars they were similar in nature as both were by way of incentive for installation of new ma chinery or plant
The initial depreciation or the develop ment rebate was to be allowed as the case may be at a certain percentage of the actual cost of the machinery or the plant for the year of installation only
It was not a recurring allowance for the subsequent years like the allowance of the normal depreciation or the additional depreciation
The Taxation Enquiry Commission in its report aforesaid had recommended in Chapter VII page 98 of Vol
II for assisting the expansion and development of productive enterprise by allowing them a proportion of new investment in fixed assets to be charged to current costs of production thereby permitting the taxable profits to be brought down to that extent
In the Finance Act of 1955 a provision was made to allow a development rebate of 25 of the cost of all new plant and machinery installed for business purposes instead of the then existing initial depreciation allowance of 20
It would thus be seen that by way of an incentive for installation of new machinery and plants initial depreciation allowance of 20 was replaced by a develop ment rebate of 25
But it was like grant of export rebate by way of incentive to make more exports in the nature of an incentive for setting up new machineries and plants
We do not find any warrant for accepting the contention of Mr Rajgopal that the initial depreciation or the develop ment rebate was allowed as an extra deductible allowance of business expenses in the year of installation of new machin ery for meeting the ever increasing costs of its replacement in future years
In our opinion it was meant merely to reduce the tax liability of the assessee in order to give him an incentive to instal new machineries or plants
The Gujarat High Court in the case of Viramgam Mills Co Ltd supra was concerned with the question as to whether the normal depreciation reserve of  the Company could be taken to be the accumulations of past profits within the meaning of the proviso to section 23A of the 1922 Act as it stood at the relevant time
It held that it could not form part of the accumulated past profits as in the words of Wixon vide Wixon s Accounts Hand Book it was the estimat ed 645 expiration of asset value or as observed by Paton in his Accountants  Hand Book Third edition it is an out of pocket cost as any other cost
Says the learned author in the above book at p 746 thus There is still widespread misapprehension as to the precise significance of the depreciation charge
It is often deemed a more or less imagi nary and hypothetical element and is sharply contrasted with the regular out of pocket oper ating costs
As a matter of fact there is nothing at all imaginary about depreciation as a cost of business operation and at bottom it is just as much an out of pocket cost as any other
The deprecia tion charge is merely the periodic operating aspect of fixed asset costs and there is no doubt as to the reality of such costs
Far from being a non out of pocket charge depreciation represents the extreme example of prepayment Mr ST Desai learned counsel for the Revenue drew our attention to the decision of the Calcutta High Court in Commissioner of Income tax
Calcutta vs Sri Bibhuti Bhusan Dutt1 and submitted that it has taken a view different from the one taken by the Gujarat High Court even in regard to the nature of normal depreciation allowance
The Calcut ta case seems to be one of a property holding company the profits of which were assessable under section 9 wherein the question of depreciation was not relevant
It is not neces sary for us to examine in this case the exact nature of the normal depreciation allowance and whether it is deductible from the profits of a person while determining his commer cial profits
The view expressed by the Gujarat High Court seems to be reasonably plausible and correct and for the purposes of this case we shall assume it to be so
Yet we do not feel persuaded to accept the argument of the assessee and equate the initial depreciation or the develop ment rebate with the normal depreciation
In our opinion such an allowance is in no sense a deductible item of cost or expenditure in the process of settlement of the commer cial profits
Although it does not form part of the assessable profits undoubtedly it does form part of the commercial profits
Tea Estate India Pvt Ltd vs Commissioner of Income tax West Bengal 11 and vice versa2 one of us Khanna J delivering the judgment on behalf of the Court has interpreted the expression accumulated profits occur ring in clause c of section 26A of the 1922 Act to include the amount of development rebate in the commercial sense
It has been stated at page 794 The acceptance of the contention would necessarily postulate reading in section 26Ac the words accumulated profits as are liable to be taxed under the Act
The words as are liable to be taxed under the Act are not there in the definition and it would not in our opinion be permissible to so construe the clause as if those words were a part of that clause
There is also nothing in the language 1 2 646 Or Context of that clause as would warrant such a construction
Accumulated profits would retain their character as such even though a part of them were not taxed as profits under the Act
 The purpose of section 2 6A of the 1922 Act corresponding to section 222 of the 1961 Act is to include within the term dividend for the purpose of taxation certain distri butions or payments of certain items of money or the like as deemed dividend for the purpose of taxation
Under clause e an advance or loan or money to a shareholder by a pri vate Company has been directed to be treated as dividend to the extent to which the Company possessed accumulated profits
The advance or the loan by a legal fiction is to resemble the actual dividend
For the purpose of distribu tion of the dividend the amount of development rebate could form part of the profits of the Company a fortiori it would be so far the purposes of clause e also
During the course of the arguments of this appeal our attention was directed to a new facet of the question under consideration and that is this
In clauses a to d of section 26A of the 1922 Act so also in the corresponding clauses of section 222 of the 1961 Act the expression accumulated profits is qualified by the expression whether capitalised or not
But the latter phrase is conspicuously absent in clause e
What is the purpose of this difference in the phraseology of the various clauses of sub section 6A  The reason is not far to seek and yet not helpful to the assessee in this case
The profits of a Company can be capitalised in accord ance with the Articles of Association and the law
On the capitalisation of the profits they cease to be profits in the hands of the Company
The nature of the asset is changed although it does not make any difference in the total assets of the Company
But profits stand transmuted and transformed into capital
The most common example of capitalisation of profits is by issuance of bonus shares to the shareholders
Clause a to d were intended by the Legislature to cover the cases of accumulated profits even though they may be capitalised
But the Legislature did not intend to rope in the capitalised profits in clause e
We may add that though under clause b distribution by a Company of debentures debenture stock or deposit certifi cates in any form in lieu of capitalised profits is to be deemed dividend within the meaning of sub section 6A mere distribution of bonus shares after capitalising the accumu lated profits unless the distribution entails the release by the Company to its shareholders of any part of the assets of the Company is not to be a deemed dividend
Even under the 1961 Act distribution of bonus shares to the equity shareholders after capitalising the profits in accordance with law is not to be a deemed dividend although distribu tion of such shares to preference shareholders is
It is thus clear that if money is paid to a shareholder of a private company by way of advance or loan after the accumu lated profits have been capitalised in accordance with the law and the Articles of Association then such payment although it may represent a part of the assets of the Compa ny or otherwise cannot be co related to the capitalised profits of the Company
To the extent the profits have been capitalised the Company cannot be said to possess any accu mulated profits
647 But the Obvious difficulty in the way of the appellant is that the accumulated profits of the Company in the year in question were never capitalised
Mere transferring the sum of Rs 236470 by debiting it to the profit and loss account to the development reserve account did not amount to the capitalisation of profits
The nature of the assets in the hands of the Company did not change
It remained profits in the hands of the Company
According to the Dictionary of English Law by Earl  Jowitt Vol
1 capitalisation means the conversion of profits or income into
capital eg by resolution of a company
Buckley on the Companies Acts thirteenth edi tion has pointed out at page 907 Profits carried to re serve do not cease to be profits unless and until they are effectually capitalised
Says the learned author at page 912 after referring to Article 128 corresponding to Regula tion 96 of Table A of the Indian Companies Act A company may if its constitution so al lows capitalize profits instead of dividing them by applying them in paying up unissued shares or debentures or other securities and issuing such shares or securities as fully paid to its members thereby transferring the sum capitalized from profit and loss or reserve account to share or loan capital account
 To the same effect is the statement of the law to be found in Palmer s Company Law twenty first edition page 673
The capitalisation of profits
says the learned author means that profits which otherwise are available for distribution among the shareholders are not divided among them in cash but that the shareholders are allotted further shares or debentures which are paid up wholly or in part out of  those profits
The amount paid by the company out of its divisible profits on account of these newly issued shares is known as the bonus and the shares are referred to as bonus shares Lord Herscheil in the case of Ann Bouch and Wil liam Bouch vs William Bouch Sprou1 was considering as to what was the nature and substance of the transaction in question in that case
The learned and the noble Lord said at page 398 I think we must look both at the substance and form of the transaction  
And it was obviously contemplated and was I think certain that no money would in fact pass from the company to the shareholders but that the entire sum would remain in their hands as paid up capi tal And finally it was said at page 399 I cannot therefore avoid the conclusion that the substance of the whole transaction was and was intended to be to convert the undivided profits into paid up capital upon newly creat ed shares
 The Madras High Court has pointed out in Commissioner Income tax Madras vs
K Srinivasan and others2 to quote the placitum only For the purposes of section 26Ae of the Income tax Act 1922 accumulated profits include general reserves
1 12 Appeal Cases 385
2 648 Unless the profit is capitalised in some form or other mere transfer of the profits to any reserve account will not take away from profits the charac ter of accumulated profits
 In Sheth Haridas Achratlal vs Commissioner of Income tax Bombay North Kutch and Saurashtra Baroda1 Chief Justice Chagla delivering the judgment on behalf of the Bench of the Bombay High Court said at page 690 But when we compare the language used by the Legislature in sub clauses a b and d and when we note the omission of the qualifying words in sub clause c then it is clear that the Legislature advisedly did not intend to subject to tax those accumulated profits which had been capitalised
 It appears that the ex pression capitalised or not was added in clause c after this decision
For the reasons stated above we hold that the develop ment rebate reserve created by the Company by duly charging the amount of profit and loss account although liable as a deduction under the 1922Act constituted accumulated profits of the Company Within the meaning of section 26Ae
We accordingly affirm the decision of the High Court and dis miss this appeal but in the circumstances make no orders as to costs
VPS Appeal dismissed


Summary:
Under section 26Ae Income Tax Act 1922 dividend includes any payment by a company not being a company in which the public are substantially interested within the meaning of section 23A of any sum by way of advance to a share holder to the extent to which the company possesses accumu lated profits
The appellant assessee was a shareholder in a company in which the public were not substantially interested within the meaning of section 23A
He had withdrawn some amounts from the company s account
The company had been allowed devel opment rebate under section 102vi b and that amount was debited in the profit and loss account of the company for the accounting year leaving a small balance of profit in the profit and loss account
The Appellate Assistant Commis sioner treated the entire sum that is the amount allowed as development rebate and the amount of balance in the profit and loss account as the amount of accumulated prof its possessed by the company
Treating the withdrawals by the appellant as advances by the company to him and finding the highest amount of advance to the assessee to be within the total figure of accumulated profits as arrived at by him he directed the addition of the advance to the asses see s income as dividend under section 26Ae of the Act
The Tribunal held that the development rebate was not liable to be treated as accumulated profits but on reference
the High Court substantially confirmed the order of the Appel late Assistant Commissioner
On the question whether the development rebate could be treated as accumulated profits in the hands of the company under section 26Ae the appellant contended that the develop ment rebate being identical with initial depreciation is in the nature of depreciation allowance and since it is de ductible from the assessable profits of the company it is also a type of outgoing expenditure or out of pocket cost and was therefore deductible from the company s commercial profits
Dismissing the appeal HELD The development rebate reserve created by the company although it does not form part of the assessable profits undoubtedly forms part of the commercial profits and hence constituted accumulated profits of the company within the meaning of section 26Ae
648D 1 The term profits  in taxation law varies in its meaning according to the context
The expression accumu lated profits  occurring in section 26A means profits in the commercial sense that is profits in the real and true sense of the term and not assessable or taxable profits
642E ED Sassoon  Company Ltd and Others vs Commissioner of Income tax Bombay City at page 46 Commission er of Income taX Bombay vs Ahmedbhai Umarbhai
 Co Bombay 18 ITR 472 at 502 Commissioner of Income tax
Bombay City vs Bipinchandra Maganlal  Co Ltd and Gobaid Motor Service P Ltd vs Commissioner of Income tax Madras followed
2 Although they are not identical and differ in some material particulars initial depreciation and development rebate are similar in nature as both are by 639 way of incentive for installation of new machinery or plant
But the initial depreciation or the development rebate is not a recurring allowance for the subsequent years like the normal depreciation allowance provided in section 102vi or the additional depreciation provided in section 102vi a
The normal depreciation and the additional depreciation are permitted to be deducted from the written down value
But the amount of the initial depreciation is not deductible in determining the written down value
644D E 3 Normal depreciation reserve of the company may not form part of the accumulated past profits as held in Commis sioner of Income tax Bombay vs Viramgam Mills Co Ltd But since the initial depreciation or the devel opment rebate cannot be equated with normal depreciation it is not a deductible item of cost or expenditure in
arriving at the commercial profits
The initial depreciation or the development rebate is not allowed as an extra deductible allowance of business expenses for meeting the costs of replacement in future years but they are meant merely to reduce the tax liability of the assessee for the year of installation only in order to give him an incentive to instal new machinery or plant 645D F 4 The purpose of section 26A is to include within the term dividend  for the purpose of taxation certain dis tributions or payments as deemed dividend
Section 26Ac provides that dividend  includes any distribution to the shareholders liquidation to the extent to which the distri bution is attributable to accumulated profits
In Tea Estate India Pvt Ltd vs CIT W Bengal it was held that accumulated profits in cl
c include devel opment Tebate
If for the purpose of distribution the amount of development rebate could form part of the accumu lated profits of the company a fortiori it would be so far the purpose of cl
e also
646B 645G 5 The use of the expression whether capitalised or not  as qualifying the expression accumulated profits  in cls
a to d but not in cl
e shows that the legisla ture does not intend to rope in capitalised profits in el
That is to the extent the profits have been capita lised in accordance with the law and its Articles of Associ ation a company cannot be said to possess any accumulated profits
But in the present case the accumulated profits of the company were never capitalised
Merely transferring the sum to the development reserve account by debiting it to the profit and loss account did not amount to capitalisation of profits
The nature of the assets did not change out continued to remain as profits
646E G 647A B Ann Bouch and William Bouch vs William Bouch Sprou 12 Appeal Cases 385 applied
Commissioner of Income tax Madras vs
K Srinivasan and others approved
Sheth Haridas Achratlal vs Commissioner of Income tax Bombay North Kutch and Saurashtra Baroda referred to