Madras High Court
Tractors & Farm Equipments Ltd. vs Deputy Commissioner Of Income Tax. on 29 December, 1993
Equivalent citations: (1994)49TTJ(MAD)500
ORDER
S. KANNAN, A.M. :
Common issue No. 1 - Treatment to be given to depreciation differential/Aggregate depreciation differential in the context of r. 1(iii) of the Second Schedule to the Companies (Profits) Surtax Act, 1964.
This issue is common to all the six assessment years.
2. This issue given rise to the following two common questions :
(i) Whether the excess of the amount allowed as and by why of depreciation allowance in the income-tax assessment over the amount of depreciation charged in the books of account of the assessee (the differential for short) will go to reduce the capital base for purposes of surtax; and
(ii) Whether the capital base for the purpose of surtax must be reduced by the depreciation differential as on the first day of the previous year relevant to the assessment year or by the aggregate of such differentials (the aggregate differential for short) relevant to the first day of the previous year(s) relating to the earlier assessment year(s) ?
3. These common questions have arisen for consideration in the number of other cases, which were all heard together.
4. For the reasons detailed in the Annexure to this order, which may be read as part of this order, we decide both the questions in favour of the assessee. We further direct the Assessing Officer to modify the surtax assessments accordingly.
Issue No. 2- Investment Allowance Reserve - Rule 4 of the Second Schedule to the Companies (Profits) Surtax Act, 1964
5. This issue is common to the asst. yrs. 1983-84 and 1984-85.
6. Even while taking into account the investment allowance created by the assessee for purposes of computing the capital base of the assessee - company for the purposes of surtax, the Assessing Officer, purporting to invoke the provisions of r. 4 of the Second Schedule to the Companies (Profits) Surtax Act, 1964, carried out an adjustment in relation to the investment allowance actually allowed to the assessee. In the process, he reduced the capital base pro tanto.
7. On his part, the CIT(A) declined to interfere in the matter.
8. On hearing both the sides, we are of the opinion that the assessee is entitled to succeed.
9. The IT Act imposes a charge on the total income of an assessee. On its part, the Companies (Profits) Surtax Act, 1964 levies additional tax on the total income of a company in the manner stipulated by the Act. Surtax is levied basically on the excess of chargeable profits over the statutory deduction. The First Schedule to the Act contains the rules for computing the chargeable profits. Briefly stated chargeable profits are computed by taking as the starting point the total income computed under the IT Act and by adjusting it in the manner stipulated in the Schedule.
The second Schedule contains rules for computing the capital base of a company. Once the capital base is computed, the determination of the statutory deduction is merely an arithmetical exercise because, by definition [see s. 2(8) of the Act], statutory deduction means an amount equal to 15% of the capital base.
10. Under the scheme of the IT Act, however, certain types of income, profits and gains are not includible in the total income of the assessee-company as computed under the IT Act. However, the aggregate of such types of income gets reflected in the capital base of the company which, as pointed out earlier, is essentially shareholders funds. Since income-tax is not exigible on such categories of income, Parliament in its wisdom thought that part of the capital base represented by such income should be left out of reckoning for purposes of computing the statutory deduction.
11. Now, the question that arises for consideration is whether the investment allowance granted to the assessee under s. 32A of the Act could be treated as "Income, profits and gains not includible in the total income". As we see it, neither in law nor in logic is there any warrant for treating the said allowance as income not includible in the total income of the assessee.
12. The scheme of the IT Act in this regard is very clear and that is that investment allowance is a deduction allowed in the process of computing the total income of the assessee.
Two significant points may here be made. First, it will be strange to treat an allowance as an item of income of the assessee-company, that too as an item of income of the type that does not enter the computation of the total income. Secondly, as pointed out earlier, a deduction in respect of the allowance is granted from the income that is chargeable to tax to start with. It should, therefore, follow that the Assessing Officer misdirected himself in law when he thought that he could invoke the provisions of r. 4 of the Second Schedule to the Companies (Profits) Surtax Act, 1964 for making the impugned adjustment.
13. In this connection, it may be highlighted that it was on the basis of the aforesaid consideration that Courts [including the Madras High Court - see Addl. CIT vs. Bimetal Bearings Ltd. (1977) 110 ITR 131 (Mad)] have held that deductions allowed under Chapter VI-A of the Act cannot be subject-matter of the adjustments contemplated by r. 4 of the Second Schedule to the Companies (Profits) Surtax Act, 1964.
14. In view of the foregoing, therefore, we set aside the impugned orders of the lower authorities on this issue and direct the Assessing Officer to compute the capital base by leaving out of reckoning the investment allowance granted to the assessee.
15. In the result, the appeals are allowed.
ANNEXURE Interpretation of r. 1(iii) of the Second Schedule to the Companies (Profits) Surtax Act, 1964 The basic question here is whether the excess of the amount allowed as and by way of depreciation allowance in income-tax assessment over the amount of depreciation charged in the books of the assessee (the differential, for short) will go to reduce the capital base for the purposes of surtax. A related question also arises and that is whether the capital base for the purpose of surtax must be reduced by the differential as on the first day of the previous year relevant to the assessment year, or by the aggregate of such differentials (the aggregate differential, for short relating to the first day of the previous year(s) relevant to the earlier assessment year(s).
Both the aforesaid questions will have to be decided on a proper interpretation of the provisions of r. 1(iii) of the Second Schedule to the Companies (Profits) Surtax Act, 1964 which lays down the rules for computing the capital of a company for the purposes of surtax. Obviously, if the answer to the first question is No, then the second question will not survive.
2. The case of the assessee is that, on a proper interpretation of the provisions of r. 1(iii) of the Second Schedule, no reduction in the capital base is called for, either in respect of the differential or in respect of the aggregate differential. The Department naturally opposes the said stand. Detailed arguments were advanced on behalf of both the assessees and the Department, in support of their respective stands.
We may deal at the outset with the argument of the Department, based on the principle of precedent.
3. Shri Raghavan, the learned Departmental Representative, drew our attention to the fact that the entire matter stood decided, in favour of the Department, by the Bombay case of CIT vs. Zenith Steel Pipes Ltd. (1978) 112 ITR 215 (Bom). He also drew our attention to the further fact that the Supreme Court has dismissed the appeals filed by the assessee in the said Bombay case-see Zenith Ltd. vs. CIT (1993) 200 ITR 572 (SC). According to him, the matter having thus reached finality, all the assessees appeals on this issue deserved to be dismissed without much ado.
In this connection, he referred to and relied upon the Karnataka case of Hindustan Machine Tools Ltd. (No. 3) vs. CIT (1989) 175 ITR 220 (Kar) in support of the proposition that "a judgment of the Supreme Court in which a question of law has been decided, does not lose its binding authority as a precedent just because a particular aspect or point was not urged before the Supreme Court". In that case, the High Court has referred to the Supreme Court case of Somawanti vs. State of Punjab 33 Comp. Cas. 745 in which it had been held :
"....... The binding effect of a decision does not depend upon whether a particular argument was considered therein or not, provided that the point with reference to which an argument was subsequently advanced was actually decided."
4. On his part, Shri Ramamani, the learned counsel for the assessee, contended first that in Zenith Ltd. (supra), the Supreme Court affirmed the decision of the Bombay High Court in Zenith Steel Pipes Ltd. (supra) and dismissed the appeals filed by the said Bombay assessee not on an examination of the merits of the case, but in view of the statement of the counsel that the issues were covered against the appellant by one or other of the pronouncements of the Supreme Court. According to him, in the context of the statement of the counsel, the Supreme Court did not have any occasion to decide the legal questions after hearing both the sides.
Secondly, in the cases before us, he would be raising contentions which were not raised before the Bombay High Court - contentions that have a direct bearing on the proper interpretation of the provisions of r. 1(iii) of the Second Schedule to the Companies (Profits) Surtax Act, 1964. Particularly, in view of the fact that in the case of Zenith Ltd. (supra), the Supreme Court dismissed the assessees appeals in view of the statement of the counsel, it was open to him to urge contentions to show the Bombay case came to be wrongly decided.
In this regard, he referred to and relied upon the Supreme Court case of Goodyear India Ltd. vs. State of Haryana (1991) 188 ITR 402 (SC) in support of the proposition that "a decision on question which has not been argued cannot be treated as a precedent". In that case, the Supreme Court had followed its own decision in the case of Raipur Ruda Meha vs. State of Gujarat 2 SCR 353 : AIR 1980 SC 1707.
On this issue, Shri Ramamani finally submitted that even if the Tribunal were to be inclined to hold that the matter stood decided against the assessees by the Supreme Court case of Zenith Ltd. (supra), the Tribunal might take not of his arguments relating to the proper interpretation of r. 1(iii) of the Second Schedule.
5. We consider that the points urged by Shri Ramamani are well taken. It is ex facie clear from the short report of the Supreme Court case of Zenith Ltd. (supra) that the Supreme Court "placed on record" the submission of the learned counsel (to the effect that the various issues arising in the appeals before the Supreme Court stood covered against the appellant by one or the other of the earlier pronouncements of the Supreme Court) and dismissed the appeals.
Taking into account the said circumstance, we consider that, in the interests of substantial justice, the matter needs to be decided on hearing both the sides. We proceed to do so.
6. In all the cases before us, which are centred on the proper interpretation of r. 1(iii) of the Second Schedule, it is common ground that the amount of depreciation allowed as deduction for purposes of income-tax assessment was in excess of the amount of depreciation charged in the books of account of the assessee. The Assessing Officer took the line that had the amount of depreciation actually allowed as deduction in income-tax assessment been charged in the books of account of the assessee, the surplus available for appropriation would have got reduced pro tanto, and that, in the process, the amount appropriated towards reserves would have also shrunk in size pro tanto. Rule 1(iii) talks of other reserves being reduced by the amount credited to such reserves as have been allowed as a deduction in computing the income of the assessee-company for the purposes of the IT Act. The term other reserves encompasses general reserve also. By reason of the assessees charging to profits a lesser sum as and by way of depreciation, the differential went to augment the general reserve. In the income-tax assessments, however, deduction had been allowed in respect of the differential. Therefore, the general reserve needs to be reduced pro tanto by virtue of the provisions of r. 1(iii). The same consideration will apply, with equal force, to the aggregate differential.
7. In this regard, the Assessing Officer referred to and relied upon the Bombay case of Zenith Steel Pipes Ltd. (supra). And the first appellate authority declined to interfere in the matter.
8. Shri Ramamani, the learned counsel, who appeared on behalf of most of the assessees, strongly contended that the lower authorities were not justified in interpreting the provisions of r. 1(iii) the way they had done. Drawing our attention first to the provisions of r. 1(iii), he contended that it authorises modification of the capital employed in the stipulated manner. Broadly speaking, the rationale behind the said provisions is that a reserve cannot be created out of the amounts allowed as a deduction for the purposes of income-tax.
In the context of depreciation allowance, however, it could be an oversimplification to say that the excess of income-tax depreciation over a book depreciation will fall within the exclusion incorporated in r. 1(iii). For more than one reason. First, it is wrong to assume that the profit representing the differential has necessarily to be connected with the general reserve, so as to justify a pro tanto reduction of the general reserve. In this regard, he referred to and relied upon the Andhra Pradesh case of CIT vs. K.C.P. Ltd. (1985) 151 ITR 455(AP) in support of the proposition that there can be no "tracing of a particular amount to a particular fund". In this regard, he highlighted the fact that the Andhra Pradesh High Court laid down the said principle only in the context of the true interpretation of the provisions of r. 1(iii) of the Second Schedule to the Companies (Profits) Surtax Act, 1964.
9. The second limb of Shri Ramamanis arguments was that, in its application, r. 1(iii) is limited to those reserves which are reserves simpliciter, and the amount credited to such reserves are nevertheless allowed as a deduction while computing the assessees taxable income under IT Act. In this regard, he drew our attention to the fact that the very IT Act, 1961 supplies three such instances, namely, (i) reserve of the type referred to in s. 36(1)(viii) of the Act; (ii) reserve of the type referred to in s. 36(1)(viiia) of the act; and (iii) reserve of the type referred in r. 6E of the IT Rules, 1962. The first two instances cover the special reserves created in pursuance of the regulations governing financial corporations of the type referred in s. 36(1)(viii) , or, as the case may be, scheduled banks of the type referred to in s. 36(1)(viiia). The third instance covers reserve for unexpired risks created in compliance with the regulations governing insurance business (other than life insurance business).
Normally, the amounts appropriated to the said three types of reserves are not revenue deductible. Even so, by virtue of the special provisions contained in s. 36(1)(viii) /36( 1)(viiia)/r. 6E, the amount credited to such reserves is allowed as a deduction to the extent specified in the IT Act. According to Shri Ramamani, it is such types of reserve that are hit by r. 1(iii) of the Second Schedule to the Companies (Profits) Surtax Act. There is no statutory warrant to travel beyond the aforesaid three types of reserves.
10. Shri Ramamani then highlighted the fact that in the Bombay case of Zenith Steel Pipes Ltd. (supra), there is no discussion on the aforesaid aspects of the case. As for the Supreme Court decision in Zenith Ltd. (supra), these aspects could not be examined, because the appeals were dismissed after placing on record the submissions of the counsel.
11. The next limb of Shri Ramamanis argument was that it is not the scheme of the Surtax Act that the Assessing Officer should be permitted to break the balance sheet of the assessee-company and to make inroads into it in the guise of making adjustments not specifically contemplated by the Companies (Profits) Surtax Act.
12. In view of the foregoing, therefore, contended Shri Ramamani, on a proper interpretation of the provisions of r. 1(iii) of the Second Schedule, there is no warrant to reduce the capital base of the assessee by the differential.
13. On his part, Shri S. S. Mani, the learned counsel for some of the assessees, supplemented the argument of Shri Ramamani, by contending first that if it is assumed that the differential is a reserve, it is not a reserve created by the board of directors which alone is competent to make appropriations towards reserves. Therefore, the provisions of r. 1(iii) cannot be invoked to support the reduction in capital base effected by the lower authorities.
14. Secondly, whenever Parliament had intended that the capital base must be reduced on certain count, Parliament had taken care to specify them. Rule (1A) exemplifies such a situation. Parliament wanted to pre-empt the attempt to inflate the capital base by the simple expedient of making inadequate provision or no provision at all for taxation/dividends. It was, therefore, the Parliament inserted r. (1A) into the Second Schedule through the Finance Act, 1976 w.r.e.f. 1st April, 1975. If it was the intent of Parliament that the differential should go to reduce the capital base pro tanto, Parliament would have made specific, clear and unambiguous provisions in that regard. Parliament has not done so. It is, therefore, not permissible to interpret the provisions of r. 1(iii) in a manner not specifically authorised by Parliament.
15. Turning next to the related issue, namely, whether the aggregate differential would go to reduce the capital base, Shri Ramamani contended that it would not. In this regard he referred to and relied upon the following cases :
(i) Maharashtra Scooters Ltd. (1993) 46 ITD 382
(ii) Order dt. 8th Feb., 1991 of the Tribunal, Madras Bench, E in the case of M/s Facit Asia Ltd. STA No. 37/Mad/87 r/w Corrigendum.
16. On his part, Shri S. S. Mani made the following points on this issue. According to him, even if it is assumed that the differential on the first day of the relevant previous year could be deducted from the capital base, there is no warrant to deduct from the capital base the aggregate differential. According to him, there might be cases in which a part of the general reserve had been capitalised in earlier years. Such capitalisation meant a reduction in the general reserve and a pro tanto increase in the paid up capital. Now r. 1 of the Second Schedule does not contemplate any adjustment as respects paid up capital. Therefore, even on the footing that the aggregate differential went to augment the general reserves, as long as the amount capitalised out of the general reserve is more than the amount represented by the aggregate differential, the Department cannot insist on tracing the aggregate differential to general reserve alone. The assessee has the right to attribute the aggregate differential to the amount capitalised.
Again, in the past, current years losses might have been written off to the reserves. In such circumstances also the assessee has a right to attribute the aggregate differential to the losses written off.
Or again, in the past, a part of the general reserve might well have been utilised to declare dividends. In such cases also, the assessee could attribute such payments to the aggregate differential.
According to Shri Mani, therefore, any attempt to bring within the pale of r. 1(iii) to aggregate differential is to oversimplify the matter.
17. In view of the foregoing, therefore, contended the learned counsel, the assessees are entitled to succeed on this issue.
18. On his part, Shri Raghavan, the learned Departmental Representative, strongly supported the impugned orders of the lower authorities. Apart from relying on the circumstance that the decision of the Bombay High Court in the case of Zenith Steel Pipes Ltd. (supra) has been affirmed by the Supreme Court in the case of Zenith Ltd. (supra), Shri Raghavan contended that the tracing of the differential to other reserves is possible. According to him, the provisions of r. 1(iii) are clear, namely, that the other reserves must be reduced by the amount credited to such reserves as have been allowed as a deduction in income-tax assessment. The said rule talks of other reserves in the gross. It does not identify them by name. Therefore, the lower authorities were very must justified in making the impugned reduction of the capital base.
19. The second limb of Shri Raghavans argument was that if the differential is not deducted from the capital base, the assessee would be getting a double benefit-one as and by way of deduction for income-tax purposes, and the other by way of a higher capital base which in its turn entitles the assessee to a higher statutory deduction [within the meaning of s. 4 of the Companies (Profits) Surtax Act, 1964). It could not have been the intention of the legislature to allow the assessee such a double benefit.
20. Turning next to the related issue involving the aggregate differential, Shri Raghavan argued that an adjustment in respect thereof is implicit in the provisions of r. 1(iii). He highlighted the fact that r. 1(iii) of the Second Schedule talks of both the IT Act, 1922 and the IT Act, 1961. In this regard he pointed out that in the following cases, the Tribunal have held that such adjustments can be made :
(i) Order dt. 23rd May, 1990 in the case of M/s Rane (Madras) Ltd. (STA Nos. 27 & 28/Mad/87-D Bench);
(ii) Order dt. 14th March, 1991 in the case of M/s English Electric Co. of India Ltd. (STA No. 85/Mad/87-B Bench);
(iii) Kirloskar Cummins Ltd. vs. Surtax Officer (1992) 43 ITD 232 (Pune)
21. In some cases, it had been argued that such an adjustment was not made in the earlier assessment years. According to Shri Raghavan, such an argument cannot avail the assessees. Merely because such adjustment was not made in earlier year(s). It does not mean that it could not be made in the relevant assessment year.
22. Shri Raghavan then contended that, as has been laid down by the Supreme Court in the case of Vazir Sultan Tobacco Co. Ltd. vs. CIT (1981) 132 ITR 559 (SC), excess provision is a reserve. That being so, there could possibly be no objection to hold that short provision of depreciation should go to reduce pro tanto the other reserves.
23. In his reply, Shri Ramamani summarised his arguments in the form of the following propositions and contended that the assessees were entitled to succeed.
1. The Second Schedule to the Surtax Act prescribes the method for computation of capital. The capital consists of paid up capital, stated reserves and other reserves. Rule 1(iii) of Second Schedule of the Surtax Act deals with other reserves.
2. Broadly speaking, what it provided is that the reserve cannot be created out of amounts allowed as a deduction for income-tax. There is an apparent contradiction in the sense that a reserve cannot be allowed as a deduction (as contrasted to a provision). But there are certain specific reserves which are allowed as a deduction for tax purposes. There are also items of capital expenditure allowed as a deduction [35AB, 35D, 35, etc.].
3. In the context of depreciation, it is over-simplification to say that excess of income-tax depreciation over the book depreciation, i.e., the excess of book written down value over income-tax written down value will fall under exclusion under r. 1(iii).
4. The over simplification is erroneous for the following reasons :
(a) It is wrong assumption that the profit representing the difference in depreciation has to be connected with general reserve to justify the reduction from the General Reserve, [K.C.P. Ltd. (supra) which lays down the correct principle that there is no tracing of a particular amount to a particular fund].
(b) If one compares the written down value as per the books and as per income-tax, the effect is that it will be ignoring the history of the companys assessment. The figures of reserve appearing in earlier years might have been capitalised and became part of capital or distributed as dividends or paid as tax when provision for tax was found to be inadequate.
(c) There is no discussion on these issues either at the High Court or in the apex Court in the case of Zenith Steel Pipes Ltd.
24. We have looked into the facts of the case. We have considered the rival submissions.
25. We may, at the outset, notice briefly the scheme of the Companies (Profits) Surtax Act, 1964. The IT Act imposes a charge on the total income of the assessee. On its part, the Companies (Profits) Surtax Act, 1964, levies an additional tax on the total income of the company in the manner stipulated by the Act. Surtax is levied basically on the excess of the chargeable profits over the statutory deduction. The First Schedule to the Act contains the rules for computing the chargeable profits. Briefly stated, chargeable profits are computed by taking as the starting point the total income computed under the IT Act and by adjusting it in the manner stipulated in the Schedule.
26. The Second Schedule contains rules for computing the capital base of the company. Broadly stated, under the said Schedule, the capital base is more or less equal to what in corporate accounting phraseology is known as "shareholders funds", subject to the stipulated adjustments. The capital base takes within its fold, besides the paid up share capital, reserves (both free and tied) properly so called. It will at once be clear that the size of the capital base is a function of factors such as the size of the paid up share capital and the size of the reserves. Once the capital base is computed, the determination of the statutory deduction is merely an arithmetical exercise because, by definition [see s. 2(8) of the Act], statutory deduction means an amount equal to 15% of the capital base.
27. One thing will be clear from the foregoing and that is that if the capital base is increased-inflated, if you like-the statutory deduction will get increased or inflated pro tanto, and the surtax levied will in the process get reduced. The paid up share capital of the company, which is one of the components of the capital base being fixed, does not afford any scope for manoeuvering. Reserves, on the contrary, afford large scope for manoeuvering. For more than one reason. Firstly, the Companies (Profits) Surtax Act does not contain any definition of the term "Reserve". Secondly, even the Companies Act, 1956 contains a negative definition of the said term. Thirdly, there is the anxiety of the taxpayer to enlarge the capital base by bringing under its pale as many items as possible under the head Reserves. Fourthly, the question whether a particular sum set apart by the company is a provision or a reserve was a bone of contention till the Supreme Court handed down its decision in the case of Vazir Sultan Tobacco Co. Ltd. vs. CIT (supra).
28. Parliament has, therefore, built into the Surtax Act certain provisions with a view to ensuring that the capital base does not get inflated.
29. The first safeguard is built into r. 1A of the Second Schedule. The rationale behind the said rule, which was inserted by the Finance Act, 1976 w.r.e.f. 1st April, 1975, may thus be stated. Particularly, as respects provision for taxation and provision for proposed dividends, the legislative intent was that they are provisions simpliciter and not reserves and that consequently they should not be taken into reckoning for the purposes of computing the capital base. It was, however, noticed that some of the companies were not showing provision for taxation or provision for proposed dividends in the balance sheet, but were taking the sums required on both the counts to general reserve, thereby inflating the capital base for the purposes of surtax. In order to curb this mischief, the Finance Act, 1976 inserted r. 1A under the Second Schedule, w.r.e.f. 1st April, 1975. The rule brings the axe down in all cases where no provision is made in the balance sheet either towards taxation or towards proposed dividends; and reduces the reserve by the amounts which ought to have been provided for in the appropriation accounts towards taxation and dividends. It also applies to cases where there is a shortfall in the provision made for taxation and/or proposed dividends.
30. In its application to the latter type of cases (that is to say, in cases where there has been a shortfall in the provision made for taxation and/or proposed dividends), the rule brings in the concept of reasonableness. With the result, r. 1A is not meant to be applied automatically in all cases where there has been a shortfall in the provision made towards taxation and/or proposed dividends. Where the provision made is reasonable, even if there be some shortfall, such shortfalls should be ignored.
31. The second safeguard built into the Surtax Act is to be found in the clarificatory Expln. to r. 1 of the Second Schedule. By virtue of the said Explanation, three specified items, namely, (i) surplus, i.e. balance in the P&L account, after provision for proposed allocation, namely, dividend, bonus or reserves; (ii) proposed additions to reserves; and (iii) Sinking funds, occurring, in that order, as item Nos. (5), (6) and (7) under the heading "Reserves and Surplus" in Part I-"Form of balance sheet" of Schedule VI of the Companies Act, 1956, shall not be regarded as reserves for purposes of computation of capital of the company under the provision of the Second Schedule to the Surtax Act.
32. We may at this stage notice the loading case of Vazir Sultan Tobacco Co. Ltd. (supra) in which the Supreme Court has enunciated the following principles :
Provision Provision is a retention or appropriation of a sum designed to meet depreciation, renewals or diminution in value of assets, or any known liability. Excess provision over the sum actually required is, however, a reserve. This is by operation of law [cl. 7 of Part III of Schedule VI of the Companies Act, 1956].
Reserve The Companies Act, 1956 gives a negative definition of "reserve". It any retention or appropriation of a sum falls within the definition of provision it can never be a reserve; but it does not follow that if the retention or appropriation is not a provision, it is automatically a reserve. In such cases, the true nature and character of the same will have to be decided with reference to the substance of the matter. A mass of undistributed profits cannot automatically became a reserve. Somebody possessing the requisite authority (namely, the board of directors) must clearly indicate the portion of the undistributed profits as being earmarked or separated from the general mass of profits with a view to constituting it either a general reserve or a specific reserve. The surrounding circumstances should make tit apparent that the amount so earmarked or set apart is in fact a reserve to be utilised in future for a specific purpose and on a specific purpose and on a specific occasion.
Approach One should first decide whether a retention or appropriation is a provision. If it is not a provision, one should thereafter decide its true nature and character, having regard to a host of factors, such as, intention, surrounding circumstances, etc.
33. We may now examine the provisions of r, 1 of the Second Schedule of the Companies (Profits) Surtax Act, 1964 in the light of the foregoing principles. The said rule reads as under :
"1. Subject to the other provisions contained in this Schedule, the capital of a company shall be the aggregate of the amounts, as on the first day of the previous year relevant to the assessment year, of -
(i) its paid up share capital;
(ii) its reserves, if any, created under the proviso (b) to cl. (vib) of sub-s. (2) of s. 10 of the Indian IT Act, 1922 (11 of 1922), or under sub-s. (4) of s. 32A or sub-s. (3) of s. 34 of the IT Act, 1961 (43 of 1961);
(iii) its other reserves as reduced by the amounts credited to such reserves as have been allowed as a deduction in computing the income of the company for the purposes of the Indian IT Act, 1922(11 of 1922) or the IT Act, 1961 (43 of 1961).
Explanation. - 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 of Balance sheet" given in part I of Schedule VI of the Companies Act, 1956 (1 of 1956), shall not be regarded as a reserve for the purposes of computation of the capital of a company under the provisions of this Schedule."
34. We are here concerned with r. 1(iii). What are the ingredients of the said rule ? They are :
(a) There should be reserves other than those covered by r. 1(ii);
(b) Certain amounts should have been credited to such reserves, and
(c) The amounts credited to such reserves must have been allowed as a deduction in computing the income of the assessee-company for the purposes of IT Act, 1922 or the IT Act, 1961.
35. The first criterion is that there should be other reserves. This would mean, in the phraseology of the Supreme Court, that somebody possessing the requisite authority (namely, the Board of Directors of the company) should have clearly indicated that a portion of the mass of undistributed profits of the company had been earmarked with a view to constituting a general or specific reserve.
The second condition is that certain amounts should have been credited to the reserve. Here again, such crediting of amounts to the reserve should be a conscious, overt act of the authority competent to credit such sums to the reserve.
The third pre-requisite is that the amount credited to the other reserves must have been allowed as a deduction in computing the income of the company under the IT Act, 1922/IT Act, 1961.
36. What struck us immediately on a plain reading of the said provision was that it was a contradiction to say that the amount credited to reserves have been allowed as deduction for income-tax purposes. The creation of reserves, general or specific, or even the crediting of amounts to reserves (already created), conceptually speaking, is a stage distinct in point of fact and posterior in point of time to the determination of the profits of the assessee, which, ex hypothesi, are arrived at only after making revenue deduction in respect of expenditure which had been incurred to earn the profits. In other words, the matching principle demands that against the gross returns of the assessee, the expenditure laid out to earn the returns, are set off. It is only thereafter that the time or occasion arises for making appropriations towards reserves - general or specific.
37. Since the above proposition is too obvious to merit highlighting, we posed the question : Are there any specific provisions in the IT Act which authorise a revenue deduction even in respect of certain amounts credited to reserves properly so called, which under the normal accountancy principles would not be eligible for revenue deduction in the process of deducing the true profits of the assessee ? The answer of Shri Ramamani was that there are indeed three instances in which the IT Act allows revenue deduction in respect of the amounts credited to reserves, namely, s;. 36(1)(viii) and s. 36(1)(viiia) of the IT Act, 1961, and r, 6E of the IT Rules, 1962.
38. This led to a further query; If these are the only instances, why was it that Parliament chose to phrase r. 1(iii) in a general fashion ? Why did it not make the said rule specifically applicable to the said three items only, on the lines of r.1(iii) which identifies certain reserves by name ? Was it because Parliament wanted to rope in the amounts credited to other types of reserves, which are allowed as a revenue deduction in the income-tax proceedings ? Shri Ramamani responded by stating that certain types of companies which are subject to regulation by special Rules or Act (such as companies producing electricity) might require to be brought within the pale of r. 1(iii).
39. At this stage, we wondered whether depreciation reserve might not typify another class of cases which might come under the pale or r. 1(iii). Normally, depreciation goes to reduce the historical cost of assets. The general practice of accounting for depreciation is based on the said principle. Even so, it is not unusual for companies to credit the depreciation charged to profits to depreciation reserve, account, leaving in tact the historical cost of the assets. In such cases, to the extent depreciation had been charged to profits, the historical cost of assets shown on the assets side of the balance sheet would be balanced by the amounts standing to the credit of depreciation reserve.
In the assessment to income-tax, however, depreciation would be allowed as a deduction. In such circumstances, all the ingredients of r. 1(iii) are satisfied. There is the depreciation reserve. There are the amounts credited to the said reserve. And the amounts so credited are allowed as deduction for purposes of assessment to income-tax under the IT Act, 1922/IT Act, 1961.
40. Yet another situation could well be envisaged. Suppose there is a liability in praesenti in respect of which, normally, that assessee should have made a provision proper. Suppose further the assessee, instead of making a provision therefor, sets apart the required sum as and by way of a reserve; and yet successfully claims a revenue deduction in respect of the sum in the income-tax proceedings. Such deliberate attempts to inflate the capital base are squarely hit by r. 1(iii).
41. These instances will also go to show why, unlike r. 1(ii), r. 1(iii) has been couched in general phraseology.
42. But in significant fact to be noticed is that r. 1(iii) could be invoked only if three conditions incorporated therein are satisfied and that too cumulatively.
First, there should be a reserve. And as has been held by the Supreme Court in the case of Vazir Sultan Tobacco Co. Ltd. (supra), a mass of undistributed profits cannot automatically become a reserve. Somebody possessing the requisite authority, namely, the board of directors, must clearly indicate the portion of the undistributed profits as being earmarked or separated from the general mass of profits with a view to constituting it either a general reserve or a specific reserve. In other words, the creation of a reserve postulates a conscious, overt act on the part of the board of directors.
Secondly, amounts should have credited to reserve, by a conscious, overtact on the part of the board of directors.
Thirdly, the amount credited must have been allowed as a deduction for the income-tax purposes.
43. The three instances (sic) to be found within the body of the IT Act, 1961 and the aforesaid two instances to be found outside the Act-all these instances satisfy the three cumulative conditions incorporated in r. 1(iii) of the Act. And by the same taken, r. 1(iii) can property be invoked only in those instances of the type referred to above.
44. Now, what is the position obtaining in the cases before us. Here, the fact is that the income-tax depreciation is more than the book depreciation. The question that arises for consideration is whether for this reason is whether for reason alone it can be held that the differential is hit by the provisions of r. 1(iii). To phrase the question differently, do the cases before us satisfy the three ingredients of r. 1(iii) ? As we see it, they do not. In respect of the differential, there is no reserve created by the board of directors through a conscious, overt act. Nor is there any crediting of amount to any reserve by a conscious, overt act on the part of the board of directors. Of course a large amount has been allowed in the income-tax proceedings as and by way of depreciation. But the other two conditions are not satisfied. Therefore, as we see it, on a proper interpretation of r. 1(iii) of the Second Schedule of the Companies (Profits) Surtax Act, there is no call to reduce the capital base by the differential.
In this connection, we may highlight the fact that the creation of a reserve represents a conscious, overt act on the part of the board of directors which possesses the accredited authority to create such reserves. It should, therefore, follow that, in cases of the type under consideration, the subsequent event, namely the granting of depreciation allowance in a higher sum for purposes of income-tax assessment cannot be called to aid by the Department in support of the proposition that to the extent of the differential, a reserve has been created.
45. There is yet another aspect of the matter that is noteworthy. As pointed out earlier, the Surtax Act itself contains built-in provisions to ensure that the capital base does not get artificially inflated. Thus, r. 1A of the Second Schedule is designed to bring the axe down in all cases where no provision is made in the balance sheet either towards taxation or towards proposed dividends. It also applies to cases where a short provisions is made for taxation and/or proposed dividends. And significantly, the said rule incorporates the concept of reasonableness, even in the latter type of cases.
It may be recalled that one of the contentions of the counsel for the assessees was that wherever Parliament wanted to take pre-emptive measures, it has done so in clear terms. Consequently, when neither the body of the Act, nor the Second Schedule of the Act contain any specific provision in relation to shortfall in provision for depreciation, there is no call to reduce the capital base pro tanto. This point, as we see it, is well taken.
Further, even in such cases of shortfall in the provision for depreciation, we have to introduce the element of reasonableness, as has been done by Parliament in relation to r. 1A of the Second Schedule. Now, it is common ground, the assessees have been following a particular method of providing for depreciation in their books of account. It is not the Departments case that the mode and mechanics adopted by the assessees in this regard was in any way defective or unreasonable. In other words, the Department has not brought on record any evidence to show that the method of charging depreciation adopted by the assessee is not in accordance with the accepted principles of accounting. This being so, the method adopted by the assessees could not be regarded as being unreasonable. Consequently, the differential also cannot be considered to be unreasonable. This is yet another reason why the capital base for the purposes of surtax could not be reduced by the differential.
46. The Departments case is that the income-tax depreciation is greater than the book depreciation; that if the assessee had charged to the profits the income-tax depreciation, the profits would have gone down pro tanto; and that consequently, the capital base should necessarily be reduced pro tanto. Even assuming that the said arguments of the Department have some force, we find that the Department has adopted a rather restricted focus. If, as contended by the Department, the charging to profits of income-tax depreciation would have reduced pro tanto the assessees profits, one would have expected the Department to carry the logic further and to hold that the provision for taxation made by the assessees on the basis of higher book profits is in excess of what was required to be provided in relation to the book profits as reduced by the depreciation differential. The excess provision for taxation occasioned by the adjustment of the book profits to the extent of the depreciation differential will have to be treated as reserve. This is by operation of law - See cl. 7 of Part III of Schedule VI of the Companies Act, 1956. This would mean that it at all any downward reduction of the capital base is warranted, the extent of the downward reduction could only be the difference between the depreciation differential on the one hand, and the excess provision for taxation on the other.
47. This brings us on to the question whether it is the intention of the Parliament that the balance sheet of the assessee-company should be subjected to such extensive changes amounting to mutilation. The learned counsel for the assessee, it may be recalled, contended, inter alia, that under the scheme of the Act, there was no warrant to break the balance sheet, to make inroads into it, except to the extent stipulated by and under the Act.
We agree. As we see it, the scheme of the Act is to take the balance sheet as the starting point and to make only those adjustments thereto that are specifically stipulated by the Act and the Schedules thereto. We may here highlight the significant fact that the adjustments authorised by the Act and the Schedules thereto do not entail the mutilation of the balance sheet beyond recognition. The Departments contention, however, has such an effect. We do not consider that such a wholesale recasting of the balance-sheet was intended by Parliament. This is yet another reason why the Departments contentions must fail.
48. True, in the case of Zenith Steel Pipes Ltd. (supra), the Bombay High Court has taken a view which supports the Departments contention. It is ex facie clear from the report of the said case that the contentions advanced before us and considered by us had not been advanced before the Bombay High Court. In the circumstances, with respect, we are unable to follow the said case.
49. In view of the foregoing, therefore, we hold that under the scheme of the Act, there is no warrant to reduce the capital base by the depreciation differential.
50. This brings us on the related question whether there is any warrant for reducing the capital base by the aggregate differential. We have held that there is no case for reducing the capital base by the depreciation differential. It should, therefore, follow that there is no warrant for reducing the capital base by the aggregate differential either.
In any event, the points urged by the learned counsel for the assessees on this issue have considerable force. We, therefore hold that there is no case for reducing the capital base by the aggregate differential.
51. Before taking leave of this matter, we may highlight the fact that, in the case of G.M. Omer Khan vs. CIT (1992) 196 ITR 269 (SC), the Supreme Court has held that it is necessary to avoid an interpretation of the section which leads to anomalies and which will make it invalid. We have to adopt such a construction which will make the section valid and certain. In our considered opinion, the interpretation that we have placed on the provisions of r. 1(iii) of the Second Schedule of the Companies (Profits) Surtax Act, 1964 - an interpretation based on first principles - avoids anomalies and makes the section eminently workable.