JUDGMENT [ENTITY], C.J.
1. The Income-tax Appellate Tribunal, Chandigarh Bench, has referred the following question for the opinion of this court:
"Whether, on the facts and circumstances of the case, the assessee-company is entitled to include Rs. 2,98,035 under the head 'provision for taxation,' and Rs. 70,000 being 'proposed dividends ' in the computation of reserves, by reference to which the standard deduction is to be computed ?"
2. The assessee is a private limited company. In assessment proceedings under the [ACT], for the assessment year 1963-64, (for which the relevant previous year commenced on August 1, 1961, and ended on July 31, 1962), the assessee claimed the following two items as reserves in the computation of its capital under [SECTION] to the Act:
Rs. P. 1 . Provision for taxation as on the first day of the previous year, i.e., August 1, 1961
2,98,035.00
2. Proposed dividends
70,000.00
3. The Income-tax Officer rejected the claim of the assessee. An appeal by the assessee before the Appellate Assistant Commissioner and a second appeal before the Income-tax Appellate Tribunal did not succeed. It was affirmed that the claim was unacceptable. And now, at the instance of the assessee, the present reference has been made.
4. The [ACT], charges a special tax on the amount by which the chargeable profits of a company during a previous year or years exceed the standard deduction. The standard deduction is an amount equal to 6 per cent. of the capital of the company computed in accordance with the provisions of the Second Schedule or an amount of Rs. 50,000, whichever is greater. The computation of the capital of the company is therefore, involved in determining the amount of the "standard deduction" and this in turn affects the determination of the super profits tax.
5. [SECTION] provides;
"Subject to the other provisions contained in this Schedule, the capital of a company shall be the sum of the amounts, as on the first day of the previous year relevant to the assessment year, of its paid up share capital and of its reserve, if any, created under the [SECTION] to Clause (vib) of Sub-section (2) of Section 10 of the [ACT] or under [SECTION] of the [ACT], and of its other reserves in so far as the amounts credited to such other reserves have not been allowed in computing its profits for the purposes of the [ACT], or the [ACT], diminished by the amount by which the cost to it of the assets the income from which in accordance with [SECTION] or [SECTION] or [SECTION] of the First Schedule is not includible in its chargeable profits, exceeds the aggregate of-
(i) any money borrowed by it which remains outstanding; and
(ii) the amount of any fund, any surplus and any such reserve as is not to be taken into account in computing the capital under this rule."
6. Broadly speaking, the capital of the company includes its paid up share capital and its reserves. One kind of reserve is specifically mentioned in [SECTION], and that is the development rebate reserve created under [SECTION] to [SECTION] of the [ACT], or [SECTION] of the [ACT]. [SECTION] also speaks of "otherreserves".
7. It is now well settled that a reserve is an amount set apart or appropriated for some future use. The distinction between a reserve and a provision is well-known in commercial accountancy. Provisions made against anticipated losses and contingencies are charges against profits and are, therefore, taken into account against gross receipts in the profit and loss account and the balance-sheet. Reserves, on the other hand, are appropriations of profits, the assets by which they are represented being retained to form part of the capital employed in the business : [PRECEDENT]. To constitute a provision, it must be in respect of a known liability, of which the amount cannot be determined with substantial accuracy on the relevant date. If the liability is not known on that date and an amount is appropriated or set apart for a future use, a reserve is said to be created. A reserve is created and maintained for the purpose of being drawn upon in future. If certain payments are to be made in discharge of a present liability in the course of the year to which the balance-sheet and the profit and loss account relate, such payments cannot be treated as a reserve but are of the nature of expenditure. A reserve is created out of the whole or part of the surpluses and is found in the hands of the company at the end of the year and it is reserved for application in a contingency which still lies in the future I [PRECEDENT]. It has been observed that an amount set aside out of profits and other surpluses to provide for any known liability of which the amount cannot be determined with substantial accuracy is a provision, while an amount set aside from profits and other surpluses and not designed to meet a liability, contingency, commitment or diminution in the value of assets known to exist at the date of the balance-sheet is a reserve : [PRECEDENT].
8. It is also necessary, in order to constitute a reserve, that the amount should not remain a mere undistributed mass of profits but should be earmarked as a reserve. If it is not earmarked as a reserve and is carried forward to the next accounting year it remains an undistributed mass of profits and cannot be described as a reserve. Someone with authority must on the relevant date have applied his mind to the question of creating a reserve out of the profits or other surpluses and set apart an amount as a reserve; There must be clear indication that it has been made or declared a reserve: [PRECEDENT] It is not necessary that a reserve admissible in the computation of capital should be one built out of profits: it may be created out of other surpluses also : [PRECEDENT] These constitute generally the tests on the basis of which it falls to be decided whether an amount can be treated as a reserve or not.
9. We have before us two items for consideration, provision for taxation and proposed dividends. In the case of provision for taxation, so much of that provision as relates to the discharge of tax liability which has already arisen, whether it has baen quantified or not under the relevant statute, cannot be considered as reserve. To that extent it has been earmarked for payment in satisfaction of the tax liability; it is not available to the assessee for future use. It is immaterial that the exact amount of the tax liability is not known on the date when the provision for taxation was made; it is sufficient that the tax liability has accrued.
10. If, however, the total amount of Rs. 2,98,035 includes an amount in excess of that contemplated for the discharge of a tax liability which has already arisen and the excess is intended for use in the future against a tax liability which has yet to arise, to the extent of the excess it may be said that a reserve has been created. The Tribunal has been unable to specifically state whether the provision of Rs. 2,98,035 for taxation has been earmarked for the discharge of a tax liability, which has already arisen on August 1, 1961, the relevant date under [SECTION], and a supplementary statement of the case submitted by it does not make the position clear. Apparently, when the appeal was heard before the Tribunal its attention was not drawn to the need for an investigation into this aspect of the case. It will now be for the Tribunal, when the case goes back to it for disposing of conformably with this judgment, to look into this matter.
11. As regards the amount of Rs. 70,000 shown as proposed dividends, it appears clear that on the relevant date the amount had been earmarked for the payment of dividends. The dividend was recommended by the directors of the assessee and the supplementary statement shows that, the recommendation in fact was accepted by the shareholders in general meeting. On the date when the provision was made for proposed dividends, it must be presumed that the directors expected that the recommendation in respect of dividends would be accepted by the shareholders. It was in that expectation that they earmarked the amount towards the proposed dividends. The amount was set apart for a specific purpose : it was not set apart for future use by the assessee. If the recommendation of the directors was not made by August 1, 1961, then the position is that the amount of Rs. 70,000 was still part of an undistributed mass of profits. It had not been set apart or appropriated as a reserve. On that date it cannot be said that any one with the requisite authority had applied his mind and decided that the amount of Rs. 70,000 should be set apart or appropriated from the profits and turned into a reserve for future use. Whichever way one looks at it the amount certainly does not represent a reserve.
12. Our attention has been drawn to [PRECEDENT] in which the Allahabad High Court appears to have held that certain sums representing provision for bonus, provision for taxation and provision for proposed dividends were reserves. It is necessary to point out, however, that in taking that view the court specifically observed that it was never the case of the revenue that the amounts represented liabilities which had already arisen and were not intended for future use in a future contingency. It is in that context that the decision in that case has to be appreciated. Subsequently, in [PRECEDENT] the same court held that sums representing proposed dividends and provision for taxation could not be treated as reserves because the material on the record indicated clearly that the amounts had been earmarked, the one for payment of the dividend, and the other for the discharge of a tax liability which had already accrued and merely awaited quantification by assessment. The qualitative difference in the material available in the latter case led to a decision different from that in the former case.
13. It was urged for the assessee that the Appellate Tribunal erred in deciding the case on the basis of the provisions of the [ACT], and in proceeding on the footing that because the two amounts under consideration were shown as liabilities in the balance-sheet they could not be treated as reserves for the purpose of the [ACT]. It was submitted that the expression employed in the [ACT] should not be construed by reference to the [ACT]. Now, there can be no dispute that for the purpose of determining what the assessee had in mind, and that is a question of fact, it would be pertinent to consider all relevant material on the point. The manner in which the amounts have been shown in the balance sheet furnish that material. Therefore, for the purpose of determining the state of mind and the conduct of the assessee in respect of the two amounts in question there is jurisdiction for examining how the two amounts were treated by the assessee.
14. It is also urged for the assessee that as the expression "provision" has not been used in the [ACT], it should not be taken into account in disposing of this reference. The expression "provision" is a well-known expression in commercial accountancy, and may legitimately be employed in this case for the purpose of drawing a distinction from the expression " reserve".
15. In our opinion, the amount of Rs. 2,98,035 shown as provision for taxation can be treated as a reserve only to the extent that it exceeds the tax liability which had already arisen on August 1, 1961. It will be for the Appellate Tribunal to enquire into this aspect of the case when disposing it of conformably with this judgment. As regards the amount of Rs. 70,000 shown on account of proposed dividends, this amount cannot be treated as a reserve.
16. The question referred is answered accordingly, In the circumstances of the case, there is no order as to costs.