Tulzapurkar, J.:— In this reference which has been made under section 256(1) of the Income-tax Act, 1961, at the instance of the Commissioner of Income-tax, Bombay City-II, Bombay, the following three questions have been referred to us for our opinion:

“(1) Whether, on the facts and in the circumstances of the case, the sum of Rs. 2,10,000 was no longer an addition to reserves on October 1, 1962, but reserves itself and, therefore, did not come under the mischief of the Explanation to rule 1 of Schedule II of the Companies (Profits) Surtax Act, 1964?

(2) Whether, on the facts and in the circumstances of the case, the reserve for Employees' indemnities was correctly treated as forming part of the reserves and the capital for purposes of capital computation for surtax purposes?

(3) Whether, on the facts and in the circumstances of the case, the excess reserve though forming part of the development rebate in the balance-sheet could not be said to have been allowed as development rebate and, therefore, the entire excess reserves without being reduced by any amount would form part of the reserves and thus would be entitled to be aggregated with capital for surtax purposes?”

2. The facts pertaining to each one of these questions are different, but all these questions relate to the assessment year 1964-65, the relevant previous year being year ended 30th September, 1963. The assessee in this case is a public limited company and in connection with its assessment under the Companies (Profits) Surtax Act, 1964, for the said assessment year certain items were claimed by the assessee as forming part of the reserve being includible in the capital computation of the company for the purpose of that Act and we shall deal with each of these items forming the subject-matter of the above three questions separately.

3. As stated earlier, the relevant previous year corresponding to the assessment year 1963-64 was the year which ended on 30th September, 1963. The directors appropriated out of the profits a sum of Rs. 2,10,000 towards general reserve. The relevant resolution of the board of directors that was passed in that behalf was passed in the meeting held on February 27, 1963, and the same was further approved by the shareholders at their annual general meeting on March 31, 1964. The Income-tax Officer acting under the Explanation to rule 1 of the Second Schedule of the Companies (Profits) Surtax Act, 1964, treated the general reserve of Rs. 2,10,000 shown by the company as on October 1, 1962, as not forming part of the capital as under the Explanation proposed additions to reserves were not to be regarded as reserves. In the appeal which was carried by the assessee-company to the Appellate Assistant Commissioner, the Appellate Assistant Commissioner directed the Income-tax Officer to include the said sum as part of the reserves. Against this direction of the Appellate Assistant Commissioner the department preferred an appeal to the Tribunal. On behalf of the department the self-same contention was urged that under the Explanation to rule 1 of the Second Schedule the proposed additions to reserves were not to be taken in the capital computation. On the other hand, it was contended on behalf of the assessee-company that even the balance-sheet as on September 30, 1962, had disclosed this as a reserve and it was only a statutory formality that required the sanction of the shareholders and, therefore, as on October 1, 1962, it was in fact a reserve. Reliance was placed on the case of Commissioner of Income-tax v. Aryodaya Ginning and Manufacturing Co. Ltd. [1957] 31 ITR 145 (Bom), where it had been held that the shareholders had by their resolution of June 27, 1949, decided not only that these amounts should constitute reserves but also that these amounts should constitute reserves of the company as of December 31, 1948. It was pointed out that though the decision was rendered in connection with the Business Profits Tax Act, the principle decided in that case was on all fours in the instant case. The Tribunal accepted the contention of the assessee-company and held that appropriation of Rs. 2,10,000 was a reserve which took effect from 30th September, 1962, and as such was includible in the capital computation. At the instance of the Commissioner of Income-tax the first question mentioned above has been referred to us for our opinion.

4. Mr. Joshi appearing for the revenue has invited our attention to the form of balance-sheet in Schedule VI of the Companies Act, 1956, and has particularly relied upon item No. (6) which appears under the heading reserves and surplus in the column of liabilities in that form, which item runs thus: “Proposed additions to reserve”. What was urged by Mr. Joshi was that as on September 30, 1962, this amount of Rs. 2,10,000 had been proposed as additions to the reserve and as such that would not come within the concept of “reserve” within the meaning of rule 1 of the Second Schedule. What we are really concerned with is not the last date of the accounting period, i.e, September 30, 1962, but the first date of the previous year, viz., October 1, 1962, and it is quite clear that as on that date the amount will have to be regarded as actual reserve and not as “proposed addition”. As on October, 1962, in our view, the amount formed part of the actual reserve and is outside the mischief of the Explanation to rule 1 and it is not possible to accept Mr. Joshi's contention in that behalf. Besides, we would like to refer to a decision of the Supreme Court in the case of Commissioner of Income-tax v. Mysore Electrical Industries Ltd. [1971] 80 ITR 566 (SC) the ratio of which case clearly applies to the facts of the present case. In that case the facts as indicated in the headnote were these: Out of the profits of the respondent-company for the accounting period ending March 31, 1963, the directors of the company appropriated the following amounts towards reserves on August 8, 1963: (i) Rs. 2,56,000 as plant modernisation and rehabilitation reserve; (ii) Rs. 1,00,000 as loss repatriation reserve; and (iii) Rs. 89,557 as development rebate reserve. The question was whether these amounts could be included in computing the capital of the respondent as on April 1, 1963, under rule 1 of Schedule II to the Companies (Profits) Surtax Act, 1964, for the purpose of the statutory deduction for the assessment year 1964-65. The department contended that since the appropriations were made on August 8, 1963, they could not be treated as components of capital as on the first day of the previous year, viz., April 1, 1963. The Supreme Court held rejecting the contention of the department that the determination of the directors to appropriate the amounts to the three items of reserve on August 8, 1963, had to be related to April 1, 1963, viz., the beginning of the accounts for the new year, and had to be treated as effective from that day. The three items had to be added to other items for the computation of the capital of the respondent as on April 1, 1963, under rule 1 of Schedule II to the Companies (Profits) Surtax Act, 1964. Having regard to the aforesaid decision, it seems to us clear that the view of the Tribunal is correct and the question referred to us is answered in favour of the assessee.

5. Turning to the second question the admitted facts are these: The assessee-company had been appropriating various sums to an account called “reserve for Employees' indemnities” and admittedly this was created in order to pay retrenchment compensation arising out of retrenchment of any member of the staff. The amount in question involved under this head which had been appropriated from the profit and loss account to this reserve during the relevant previous year came to Rs. 53,33055. The Income-tax Officer did not consider this item as reserve for the purpose of computation of the capital for surtax purposes because it was in the nature of a contingent liability and this sum which was subsequently transferred to the gratuity reserve became a provision for gratuity payment. The Appellate Assistant Commissioner also held that the amount appeared to him to be a provision against gratuity liability and, therefore, excluded from the capital computation. This item was the subject-matter of cross-objection which the assessee had filed in the department's appeal and in support of the cross objection it was urged on behalf of the assessee-company that as on October 1, 1962, being the relevant date, this item was only a reserve and the mere fact that subsequently there was transfer of this amount to a reserve for gratuity could not take away the character of the item as a reserve as on the material date. It was also pointed out that this amount had been set apart only out of abundant caution than out of necessity and in fact no amount of this reserve had been touched during the relevant period. It was, therefore, urged that this item should be regarded as a reserve and should be included in the capital computation for surtax purpose. On behalf of the revenue the orders passed by the lower taxing authorities were sought to be supported by placing reliance upon the Explanation to rule 1 and it was contended that even if the item may have been styled as “reserve for Employees' indemnities” it was a provision for certain liability; at any rate, a contingent liability. After referring to the definitions of the expressions “provision” and “reserve” as are to be found in clause (7) of Part III, which deals with interpretation of expressions, in Schedule VI of the Companies Act, 1956, the Tribunal took the view that under clause 7(b) it was clear that the expression “reserve” did not include any amount retained by way of providing for a known liability and in its view the appropriation for Employees' indemnity could not be said to be an appropriation designed to meet any known liability as there was no liability to pay any retrenchment compensation for which the reserve had been set apart. In this view of the matter the Tribunal held that this particular item was nothing but a reserve and was includible for the purpose of capital computation for surtax purposes. The Commissioner has challenged this finding of the Tribunal and has got the second question referred to us for our opinion.

6. Mr. Joshi for the revenue invited our attention to the Explanation to rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964, which runs thus:

“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 to 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.”

7. After referring to the aforesaid Explanation, he invited our attention to the form of balance-sheet as given in Part I of Schedule VI of the Companies Act, 1956, where he pointed out that in the column “Liabilities” under the heading “Current liabilities and provisions” and the sub-heading “Provisions” there were two items, being items Nos. (10) and (13), which ran thus: “Item No. (10): For contingencies, Item No. (13): Other provisions” and what was urged by him was that since this appropriation of Rs. 53,330.55, though styled as appropriation as a reserve for Employees' indemnities, in substance it will have to be regarded as a provision for contingency or other provisions falling within item No. (10) or item No. (13) under the heading “Current liabilities and provisions”, for, according to him, after all it was an admitted position that this so-called reserve was created in order to pay retrenchment compensation arising out of retrenchment of any member of the staff which was the object with which this reserve was created; he urged that this must be regarded as contingent liability, a liability to pay compensation arising out of the contingency, viz., retrenchment of any member of the staff. In support of his aforesaid argument reliance was placed by him upon the definition of the expressions “provision” and “reserve” given in clause 7(1)(a) and (b) of Part III of Schedule VI to the Companies Act, particularly the latter part of the definition. Under clause 7(1)(a) of Part III of Schedule VI the expression “provision” has been defined in a particular manner and under clause 7(1)(b) the expression “reserve” has also been defined in a particular manner and, after setting out these definitions, clause 7(1)(a) runs thus:

“and in this sub-clause the expression ‘liability’ shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities.”

8. What was urged by Mr. Joshi was that though the expressions “provision” or “reserve” have been defined as meaning certain things, under the latter part of clause 7(1) the definition of “liability” is an inclusive definition and, therefore, has been given a wide meaning so as to include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities. In other words, according to Mr. Joshi, the expression “liability” has been defined in an inclusive manner and, therefore, would be wider than the definitions of the two expressions “provision” and “reserve” given in sub-clauses (a) and (b) of clause 7(1). Mr. Joshi has, therefore, contended that this item which is styled as “reserve for Employees' indemnities” would be nothing but a provision made for contingent liability arising upon retrenchment of any member of the staff and as such the same could not be regarded as a reserve includible in the capital computation for surtax purposes. It is not possible to accept any of these submissions of Mr. Joshi for the reasons which we shall presently indicate.

9. In the first place, the Explanation to rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964 (which we have quoted above), on which reliance has been placed by him, would, strictly speaking, be inapplicable to the facts of the present case. All that the said Explanation says is that “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 relevant date, “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 to the Companies Act, 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”. In other words, in order that the Explanation should apply, it must be shown that in the balance-sheet of the company for the relevant period certain items falling under the heading “Current liabilities and provisions” must have been shown in the column relating to “Liabilities” in the “Form of balance-sheet” or the item must be of a nature of item (5), or item (6) or item (7) falling under the heading “Reserves and surplus”, while in the instant case the item of Rs. 53,330.55 does not appear in the column of liabilities at all in the balance-sheet for the relevant year but it occurs under the heading “Reserves and surplus” and as such the question of applying the Explanation to the facts of the present case would not arise. It may be stated at this stage that it was nobody's case that the balance-sheet of the assessee-company for the relevant period in the instant case has not been properly prepared in accordance with the provisions of the companies act or that the same is in derogation or contrary to the provisions of the companies act. That being not the case of either party, the question will have to be considered as to whether this particular item which has been shown under the heading “Reserves and surplus” could be treated in the manner suggested by Mr. Joshi by relying upon the Explanation to rule 1 of Schedule II to the Companies (Profits) Surtax Act, 1964. Since this is not an item of the nature of item (5) or item (6) or item (7) under the heading “Reserves and surplus” nor is it any of the items appearing 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 to the Companies Act, 1956, the Explanation could not be applicable thereto. But apart from this technical approach, looking at the item from the point of substance, the question would be whether this item could be regarded as a provision or a reserve and having regard to the distinction that has been made between these two concepts by the Supreme Court in Metal Box Co.'s case [1969] 73 ITR 53 (SC) it is clear that if an amount is set aside out of the profits and other surplus to provide for any known liability, it would be a provision but if an amount is set aside out of the profits or other surplus not designed to meet a liability, contingency, commitment or diminution in value of assets known to exist at the date of the balance-sheet it is a reserve. Even the two definitions of the expressions “provision” and “reserve” as given in clause 7(1)(a) and (b) respectively of Part III of Schedule VI to the Companies Act bear out this distinction. Having regard to the definitions given therein it would be clear that if any amount is retained by way of providing for any known or existing liability —known or existing at the date of the balance-sheet—it would be a provision, whereas any retention of money which is not designed by way of providing for any known liability would be a reserve. Looked at from this angle, in our view, the setting apart of the item of Rs. 53,330.55 by way of providing for Employees' indemnities intended to be spent for payment of retrenchment compensation arising out of a future or possible retrenchment of any member of the staff cannot be regarded as a provision made for any known or existing liability and, therefore, the setting apart of this item will have to be regarded as a reserve which would be properly includible in the capital computation for surtax purposes.

10. In this behalf strong reliance placed by Mr. Joshi upon the latter part of sub-clause (1) of clause 7 of Part III which defines the expressions “pro-vision” and “reserve” is, in our opinion, misplaced as even that part does not assist him to derive any support to his contention. It is true that under the latter part of sub-clause (1) of clause 7 the definition of the expression “liability” has been an inclusive definition and that expression is said to include “contingent liability” but such inclusive definition has been given for purposes of sub-clause (1) of clause 7 where while defining the expressions “provision” and “reserve” the expression “liability” is preceded by the word “known”. Therefore, even if the expression “liability” as occurring in sub-clauses (a) and (b) of clause 7(1) shall include a contingent liability, such contingent liability must be a “known con-tingent liability”. The expression “provision” is denned in sub-clause (a) of clause 7(1) thus:

“The expression ‘provision’ shall, subject to sub-clause (2) of this clause, mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be deter-mined with substantial accuracy.”

11. Sub-clause (b) of clause 7(1) defines “reserve” thus:

“The expression ‘reserve’ shall not, subject as aforesaid, include any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets or retained by way of providing for any known liability.”

and thereafter the latter part of sub-clause (1) of clause 7 proceeds to state:

“……in this sub-clause the expression ‘liability’ shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities.” It is thus clear that though the expression “liability” is defined as inclusive of contingent liabilities, even so, such contingent liabilities must be known contingent liabilities. That such would be the correct position in commercial accountancy would also be clear from what has been stated in standard works on auditing and accountancy; for instance, in Spicer & Pegler's Practical Auditing, fourth Indian edition, Part I, in Chapter which deals with the subject, “The audit of the Impersonal Ledger”, under the sub-heading “Contingent liabilities” at page 149. This is what the learned authors have stated:

“(12) Contingent liabilities.—The auditor should ascertain whether there are any transactions outstanding at the date of the balance-sheet which might involve the payment of money at some subsequent date. Such outstandings are termed ‘contingent liabilities’, and may be of two classes: the one involving a loss should the liability accrue, and the other involving the acquisition of an asset of corresponding value.

It is sufficient for the amount of the contingent liability to be stated on the face of the balance-sheet by way of a note, unless there is a definite probability that a loss will materialize, when specific provision should be made therefor. The most familiar instance is the contingent liability on bills receivable which have been discounted. If at the date of the balance-sheet any of the bills that have been discounted are outstanding, there will be a contingent liability in respect thereof, since, if the acceptors do not meet the bills on maturity, the holders will have a right of recourse against the drawer or any prior indorser……

Other instances of contingent liabilities which might involve a loss, should they accrue, would be damages and costs in the case of an action pending, forward contracts, guarantees for third parties, and speculative transactions on the stock exchange still undecided.”

12. It would thus appear that the contingent liabilities spoken of by clause 7(1) of Part III of Schedule VI to the Companies Act, 1956, would be of the type described in the above passage from Spicer & Pegler's Practical Auditing. Having regard to the above discussion, we are clearly of the view that the Tribunal was right in taking the view that the item which had been set apart under the heading “Reserve for Employees' Indemnities” had not been set apart by way of providing for known liability and as such was a reserve includible in the capital computation. The question is, therefore, answered in the affirmative, in favour of the assessee.

13. Turning to the last question, the question relates to the excess development rebate reserve provided in the accounts over and above the statutory reserves required under section 34(3)(a) of the Income-tax Act, 1961. The material facts dealing with this aspect are that the balance-sheet as on 30th September, 1962, disclosed a development rebate of Rs. 1,66,077.25 while the statutory reserves required under section 34(3)(a) of the Income-tax Act amounted to Rs. 1,65,994. Under sub-rule (ii) of rule 1 of the Second Schedule providing rules for computing the capital of a company for purposes of surtax whatever reserves created under section 34(3)(a) of the Income-tax Act, 1961, would be considered as forming part of capital for purposes of super-tax. Since the Income-tax Officer found that the reserve under the said section 34(3)(a) amounted to only Rs. 1,65,994, the excess over this amount, he held, could not be considered by him as the reserves under the said section 34(3)(a). The Appellate Assistant Commissioner also confirmed the Income-tax Officer's view. The Tribunal reversed the decision of the lower authorities and took the view that even if the company were to create a reserve as it did in this case which happened to be in excess of the statutory reserve, it had no bearing on the rebate to be allowed and it, therefore, held that the excess reserve, though forming part of the development rebate reserve in the balance-sheet, could not be said to have been allowed as development rebate and, therefore, the entire excess reserve without being reduced by any amount will form part of the reserves and thus entitled to be aggregated with capital for surtax purposes. The question raised is really covered by a circular bearing No. 53 (F. No. 7/2/68-TPL) dated January 11, 1971, issued by the Central Board of Direct Taxes. It may be stated that by this circular no particular direction for any particular year was given by the Board but the Board laid down a general principle applicable touching the point by clarifying the position thus: (See [1971] 79 ITR (St) 73):

“The amounts credited to the development rebate reserve account in excess of the statutory requirement of 75% of the development rebate in respect of which deduction is admissible under section 33 of the 1961 Act or section 10(2)(vib) of the 1922 Act can obviously not be considered as part of the development rebate reserve created under the relevant statutory provisions and cannot, therefore, be treated as ‘reserves’ within the meaning of (ii) above. The excess amounts, however, constitute ‘other reserves’ for purposes of (iii) above and would be includible in the ‘capital’ of the company if it can be said that these amounts have not been allowed in computing the profits of the company for purposes of the 1961 Act or the 1922 Act.”

14. Admittedly, in the instant case, the excess amount has not been allowed in computing the capital of the company. This item, therefore, would be clearly covered by the above circular and the assessee will be entitled to have the said excess included in the capital computation for the purpose of surtax. This question is, therefore, also answered in the affirmative, in favour of the assessee.

15. Department will pay the costs of the reference to the assessee.