The Judgment of the Court was delivered by

Rajagopalan, J.:— What should be allowed under the head “reserves” within the meaning of R. 2(1) in Sch. II, read with Section 2(1)(a) of the Business Profits Tax Act, 1947 is the main question for determination in this reference, which arises out of the assessment of the assessee company to Business fronts Tax for the chrgeable accounting penous from 1-4-1946 to 31-12-1946 and from 1-1-1947 to 31-3-1947.

2. The assessee company adopted the calendar year as its year of account. The balance-sheet for the year of account ending with 31-12-1945 showed a sum of Rs. 2,00,000, as the amount appropriated to the Reserve Account from that year's profit; and a sum of Rs. 9,00,000, was shown as provision made that year for the payment of income-tax and excess profits tax. These sums the assessee claimed should be included in the reserves for computing its capital under R. 2(1) in Sch. II for the chargeable accounting period from 1-4-1946 to 31-12-1946. In addition, the assessee claimed the inclusion of a sum of Rs. 2,73,504, which stood to its credit in the profit and loss account on 1-4-1946 and which represented the profits for the period 1-1-1946 to 31-3-1946. For the chargeable accounting period 1-1-1947 to 31-3-1947 the assessee's claim was with reference to two items shown in the balance sheet for the year of account ending with 31-12-1946 (1) Rs. 50,000, the amount appropriated from that year's profit to the reserve account, and (2) Rs. 4,75,000, the provision made that year for the payment of income-tax, business profits tax and excess profits tax.

3. The assessee's claims which were disallowed by the departmental authorities were upheld by the tribunal. At the instance of the department the tribunal referred the following questions to this Court under Section 66(1) of the Income-tax Act read with Section 19 of the Business Profits Tax Act.

1. Whether the sum of Rs. 13,73,504 or any lesser sum brought forward on 1-4-1946 from the previous year's account forms part of the company's capital within the meaning of R. 2(1) of schedule II of the Business Profits Tax Act in respect of the chargeable accounting period 1-4-1946 to 31-12-1946; and

2. Whether the sum of Rs. 5,25,000, brought forward on 1-1-1947 from the previous year's account forms part of the company's capital within the meaning of R. 2(1) of schedule II of the Business Profits Tax Act in respect of the chargeable accounting period 1-1-1947 to 31-3-1947.”

4. The relevant portions of S. 2(1) and R. 2(1) in Sch. II ran: Section 2(1):

“Abatement means in respect of any chargeable accounting period…. a sum which bears to a sum equal to in the case of a company….. 6 per cent of the capital of the company on the first day of the said period computed in accordance with schedule II…..”

5. Rule 2(1) of Sch. II:

“Where the company is one to which R. 3 of Sch. I applies, its capital shall be the sum of the amounts of its paid-up share capital and of its reserves……”

6. It was beyond controversy that the crucial dates for the determination of what was the “capital” of the company computed under R. 2(1) to include reserves were 1-4-1946 to 1-1-1947 respectively for the two chargeable accounting periods with which we are concerned in this reterence.

7. That the sums of Rs. 2,00,000 and Rs. 50,000 would be reserves within the meaning of R. 2(1), had there been a valid allocation on or before the respective dates 1-4-1946 and 1-1-1947 could not be in dispute. The learned counsel for the department contended that there was a valid and effective allocation in each of the chargeable accounting periods only subsequent to the dates specified by S. 2(1). Apart from the contention, that there was no valid allocation before the crucial dates, a further contention of the learned counsel for the department with reference to the sums of Rs. 9,00,000 and Rs. 4,75,000 set apart for payment of tax, was that they were not reserves at all within the scope of R. 2(1). The learned counsel for the assessee conceded that the claim of the assessee, that the sum of Rs. 2,73,504 constituted a reserve on 1-4-1946 for the chargeable accounting period 1-4-1946 to 31-12-1946, was unsustainable, in view of the decision of the Supreme Court in Commissioner of Income-tax, Bombay State v. Century Spinning and Manufacturing Co. Ltd., 1954 SCR 203 : 1953-24 ITR 499 : (AIR 1953 SC 501) (A).

8. We shall first deal with the question, when was an effective and valid allocation made of the sums with reference to which the abatement was claimed under S. 2(1) of the Act. As explained by the Supreme Court in 1954 SCR 203 : (AIR 1953 SC 501) (A), what we have to examine is whether any one possessed of the requisite authority indicated on or before the crucial dates, 1-4-1946 and 1-1-1947 the manner of disposal or the destination of the funds of the company which constituted its profits. Was any portion of the profits specially set apart for any purpose on or before the date specified and so set apart by one having the requisite authority?

9. We have to set out some more facts before we answer these questions. With reference to the year of account 1945, the relevant chargeable accounting period for which commenced on 1-4-1946, the position was as follows: The relevant portion of resolution No. 2 of the Board of Directors at its meeting held on 15-3-1946, ran:

“Resolved that the balance sheet, the profit and loss account and the detailed statements be approved and that the profits be allocated as follows: Rs. 9,00,000 for income and excess profits taxes. Rs. 2,00,000 for reserve fund from which the deposit under Section 10 of the Finance Act will be paid.”

10. Resolution No. 3 of the Board of Directors ran:

“Resolved that the draft report….for submission to the General meeting be approved………”

11. Paragraph 2 of the Report of the Board of Directors showed that the directors recommended an appropriation of the sum of Rs. 9,00,000 as a provision for payment of tax and a sum of Rs. 2,00,000 for transfer to the Reserve Fund to provide for the deposit under Section 10 of the Finance Act. A general meeting of the shareholders was held on 15-4-1946, and the second of the resolutions passed by them unanimously ran:

“Resolved that the directors' report, audited balance-sheet and the profit and loss account for the year ending 31-12-1945 be approved.”

12. The resolutions ran on the same lines with reference to the year of account ending with 31-12-1946, which had reference to the chargeable accounting period which commenced on 1-1-1947. In this case, however, the meeting of the Board of Directors and that of the shareholders were both after 1-1-1947, that is, 15-4-1947 and 14-5-1947 respectively.

13. With reference to the chargeable accounting period which commenced on 1-4-1946, the question for determination is, was an allocation to reserve made by the Directors on 15-3-1946, that is, before 1-4-1946, or was it made only by the share-holders on 15-4-1946.

14. The contention of the learned counsel for the assessee, that only the directors were possessed of the requisite authority to order the allocation in question, is, in our opinion, well founded.

15. Section 131 of the Companies Act enjoins on the directors of every company the duty of preparing annually a balance sheet and profit and loss account and laying them before the General Meeting of the Company & S. 131-A dealing with the contents of the Directors' report which should accompany the balance-sheet enacts:

“131. A(1): The directors shall make out and attach to every balance-sheet a report with respect to the state of the company's affairs, the amount, if any, which they recommend should be paid by way of dividend and the amount, if any, which they propose to carry to the reserve fund, general reserve or reserve account to be shown specifically in a subsequent balance-sheet.”

16. Under this provision therefore while the directors “recommend” to the share-holders the amount to be paid by way of dividends, they are the authority competent to direct the allocation to reserves and they merely intimate to the shareholders what “they propose to do.” In line with this, which merely embodied in statutory form the law as previously understood, Article 127(t) of the Assessee Company's Articles of Association, showed as one of the items of powers that the directors were expressly declared to have before recommending any dividend

“to set aside out of the profits of the company such sums as they may think proper …. for such other purpose as the director's may, in their absolute discretion, think conducive to the interests of the company.”

17. What the annual report of the directors should contain was specified by Article 152 of the Articles of Association which proceeded on the distinction between the amount which the (directors recommended to be paid out of the profits “by way of dividend or bonus to the shareholders” and the amount, if any, set aside by the directors “for the reserve fund, depreciation and renewal fund and the insurance fund or any other special fund.” The power of allocation to a reserve has to be exercised, it should be remembered, before the directors recommended a-dividend (See Article 127(t)). The learned counsel for the assessee contended that the power was exercised and the allocation was made by the directors at their meeting on 15-3-1946 and that constituted the only valid and effective allocation to reserves.

18. The learned counsel for the department urged in effect that, even if the directors, had the authority to set apart the sums in question, Rs. 9,00,000 and Rs. 2,00,000, that power was not exercised on 15-3-1946, but the directors left it to the shareholders to give effect to that allocation on 15-4-1946.

19. Despite the wording in paragraph 2 of the report of the directors for 1945, which we have extracted above, it seems clear to us that there was a completed allocation on Rs. 11,00,000, on 15-3-1946, under resolution No. 2 of the Board of directors. The Board of directors had the authority, and it exercised it. The shareholders had not the authority to interfere with what the directors had already done. Article 127(t) of the Articles of Association read in the light of S. 131-A(1) gave an absolute discretion to the directors. If the shareholders purported to ratify on 15-4-1946 what the directors had already done on 15-3-1946, that did not affect the validity or the effectiveness of the allocation already ordered by the directors, an allocation which they were entitled to order and did order before they recommended a dividend.

20. Thus, the position is that factually a sum of Rs. 11,00,000, was set apart jor the specified purposes before 1-4-1946 by the directors, who alone had the authority to do that.

21. The material date for the second of the chargeable accounting periods with which we are concerned was 1-1-1947. The allocation of Rs. 5,25,000 out of the profits was made by the directors at their meeting held on 15-4-1947. They had the requisite authority to make that allocation, but they exercised it only after the material date 1-1-1947. On that ground the second of the questions referred to this court has to be answered in the negative and against the assessee.

22. The learned counsel for the assessee further contended that, whatever be the dates on which the directors allocated the profits in the manner referred to above, these allocations became effective from the last date of the year of account in question, and it was so shown in the balance sheets for 1945–1946. He urged that there was a valid & effective allocation to reserves, with reference to each of the chargeable accounting periods before the material date specified by S. 2(1) of the Act for each of them. The learned counsel relied on Commissioner of Income-tax v. Aryodaya Ginning and Manufacturing Co. Ltd., 1957-31 ITR 145 : (AIR 1957 Bom 26) (B), in support of this contention.

23. In 1957-31 ITR 145 : (AIR 1957 Bom 26) (B), the chargeable accounting period was from 1-1-1949 to 31-3-1949. The year of account ended on 31-12-1948. The balance-sheet of the company as on 31-12-1948 showed an appropriation of a sum of Rs. 11,08,000 to the Reserve Fund and a sum of Rs. 1,50,000 to the Dividend Reserve Fund. That it was only the shareholders of the company that had the authority to effect the appropriation appears to have been accepted by both sides. In that case the meeting of the shareholders at which these appropriations were approved of was on 27-6-1949. The learned Judges held that the amounts transferred to the Reserve Fund must be taken into account in computing the capital of the company for the chargeable accounting period in question, 1st January to 31st March, 1949.

24. With all respect to the learned Judges of the Bombay High Court, we confess our inability to accept that decision as a correct interpretation of the requirements of S. 2(1)(a) of the Act. What S. 2(1)(a) requires is an ascertainment of the computed capital on the first day of the chargeable accounting period in question. It is a factual ascertainment that is contemplated and required. What was the factual position on the first day of the relevant chargeable accounting period? What was the paid-up capital on that date and what were the reserves on that date; the two together made up the capital of the company within the meaning of S. 2(1).

25. As pointed out by the Supreme Court in 1954 SCR 203 : 1953-24 ITR 499 : (AIR 1953 SC 501) (A), nothing is a reserve within the meaning of R. 2(1) in Sch. II of the Act, which has not been appropriated as a reserve by a person having the requisite authority. The manner of the disposal of the available profits must be indicated on or before the material date, the first day of the chargeable accounting period in question, by a person with the requisite authority to do so. With reference to the second of the chargeable accounting periods with which we are concerned, from 1-1-1947 to 31-3-1947 the factual appropriation was made only after 1-1-1947, that is, on 15-4-1947.

26. That appropriation, in our opinion, could not be related back to 31-12-1946, though the final balance-sheet showed an appropriation effective from that date. Till the appropriations are actually made the funds of the company available to it constitute only a mass of undistributed profits, and no portion of such undistributed profits can be called a reserve. That was made clear by the Supreme Court in the 1954 SCR 203 : 1953-24 ITR 499 : (AIR 1953 SC 501) (A).

27. In 1957-31 ITR 145 : (AIR 1957 Bom 26) (B), the learned Chief Justice referred thus to the scope of the resolution of the shareholders:

“Therefore the shareholders by passing the resolution on 27th June, 1949 did not decide that these amounts constituted reserves as from that date but they accepted the recommendation of the directors that these amounts should constitute reserves of the company as on 31st December, 1948.”

28. At page 151 (of ITR): (at p. 27 of AIR) the learned Chief Justice observed:

“…. The body of shareholders who are the persons with the requisite authority do not merely determine that a certain amount should constitute reserve, but they also determine and have the necessary authority for determining that amount should constitute reserve as from a particular date, and in this case there is no doubt that the general meeting of the shareholders was considering the accounts for the year ended 31st December, 1948, and passing resolutions with regard to those ac-counts.”

29. At page 152 (of ITR): (at p. 27 of AIR) the learned Chief Justice observed:

“in this case the profits were made at the end of 31st December, 1948, and from 1st January, 1949, the reserves were in existence and could be utilised for the working of the company as much as the capital. If that be so, the mere fact that the share-holders passed a resolution at a later date cannot affect the merits of the question or the right of the assessee company to get the benefit of the abatement provided by the business profits tax.”

30. We venture to point out that statement, that the reserves were in existence on 31-12-1948, may not be a quite correct statement of the factual position. What was in existence on 31-12-1948 in that case was a mass of undistributed profits which were available for distribution, no portion of which had been ear-marked as a reserve on that date by any person having the requisite authority to do so. What, as we have pointed out earlier, R. 2(1) requires is that the reserve should be factually in existence on the first day of the relevant chargeable accounting period.

31. There can be no reserve until there is allocation in fact by a person having the requisite authority to order that allocation. If, in the case of 1957-31 ITR 145 : (AIR 1957 Bom 26) (B), it was the shareholders that had the requisite authority, the allocation could have become effective for the purpose of R. 2(1) only from the date on which they factually exercised that authority; and they do not appear to have had the further authority to give retrospective effect to that factual allocation.

32. To sum up our conclusions on this portion of the case: with reference to the chargeable accounting period 1-4-1946 to 31-12-1946 there was a valid and effective allocation of a sum of Rs. 11,00,000 to reserves before the material date 1-4-1946. With reference to the second of the chargeable accounting periods 1-1-1947 to 31-3-1947, the sum of Rs. 5,25,000, was not validly and effectively allocated to any reserve by any one having authority to do so before the crucial date 1-1-1947.

33. Mr. Ram Rao Sahib, learned counsel for the department next contended that the sum of Rs. 9,00,000, in regard to the first chargeable accounting period and Rs. 4,75,000, as regards the next, could not really be treated as “reserves”, since they represented moneys set apart for the liquidation of tax liabilities already incurred the argument being that as the sums would be expended during the course of that year and would not be available for being carried over to the next period, they were not “reserves” on which abatement could be claimed.

34. Mr. Viswanatha Aiyar, the learned counsel for the assessee, raised a preliminary objection to permitting this contention, even if sound, being raised, since that was not the department's case at any stage of the proceedings. In our judgment this objection is sound and ought to prevail. In the first place, the point as regards the nature of the fund set apart — (as distinguished from the date when this was effectively done) — not answering to the requisites of a “reserve” within R. 2(1) of Sch. II was never raised by the Department at any stage.

35. It is not a ground mentioned by the Income-tax Officer; nor does it figure in the order of the Appellate Assistant Commissioner or of the Tribunal. No trace of it is indicated even in the statement of the case, not to speak of its forming part of the questions referred to us for decision. Moreover, the point, even as formulated by Mr. Rama Rao Sahib, involves an investigation of matters of fact which has not been done, for the obvious reason that it was not thought of earlier.

36. What we desire to indicate is that there is nothing in the record to show the exact tax liability of the company for the two “previous years”, to permit of a computation of the amount which the company would have to pay out of the sums reserved, for it is conceded by revenue that at least the excess over the sum not spent out of the sum set apart would be a reserve. This is not therefore a case of a party seeking to support an order on purely legal grounds based on admitted or established facts — as Mr. Rama Rao Sahib sought to urge.

37. Since, however, the point has been argued in full we proceed to express our views on the matter. We need only mention at the outset that the objection can have real relevance only as regards the sum of Rs. 9,00,000 set apart for the chargeable accounting period 1-4-1946 to 31-12-1946, since we have held against the assessee on both the items in the succeeding accounting period.

38. Our attention was not drawn to any reported case in which such a question was specifically decided, whether the provision for payment of taxes would constitute a reserve within the meaning of R. 2(1). Apart from the positive rule of interpretation laid down in 1954 SCR 203 : (AIR 1953 SC 501) (A), by the Supreme Court, there is one feature of that case to which we can refer, what, if we may do so with respect, is a negative aspect. At page 205 (of SCR): (at p. 501 of AIR), in the narrative of facts Ghulam Hasan, J. pointed out:

“The profits according to the profit and loss account, were Rs. 90,44,677, subject to the provisions for depreciation and taxation. After making provisions for these, the balance of Rs. 5,08,637 was carried to the balance-sheet.”

39. Apparently the validity of the appropriation for taxes as a reserve was not challenged, and their Lordships had to decide only the question., whether the balance of Rs. 5,08,637 which represented unappropriated profits, which were however not extended, constituted a reserve.

40. In 1957-31 ITR 145 : (AIR 1957 Bom 26) (B), a sum of Rs. 12,50,000, was set apart for payment of taxes. The claim of the assessee that it constituted “reserve” was negatived by the Tribunal, and the correctness of that decision does not appear to have been challenged by seeking any reference to the High Court on that point.

41. As pointed out by the Supreme Court in 1954 SCR 203 at p. 208 : (AIR 1953 SC 501 at p. 502) (A), the term “reserve” is not defined in the Act and we must resort to the ordinary natural meaning as understood in common parlance. Their Lordships then set out the dictionary meaning of the word “reserve”. One such meaning was “to set apart for some purpose or with some end in view; to keep for some use”. If that meaning were to prevail, it should be obvious that the sum of Rs. 9,00,000 was set apart for a specified purpose, with a specified end in view, payment of taxes when they fell due.

42. Reservation of a specified sum for a specified use, when the reservation has been validly made by a person having the authority to do so, would appear to bring the sum so reserved within the meaning of the expression “reserve” in R. 2(1). We should, however, make it clear that we are concerned in this case only with the question, whether the allocation of a specified sum out of the profits of the company to be kept back for utilisation towards the payment of tax is sufficient to make the sum so set apart a reserve within the meaning of R. 2(1). We are not concerned with any of the other purposes for which the Directors could have set apart a specified sum.

43. As we pointed out earlier, if the test to apply is that indicated by the dictionary meaning of the word “reserve”, those tests were satisfied. The sum of Rs. 9,00,000 was set apart. It was set apart for some purpose and was kept for some use, the purpose and use having been specified when the sum was allocated and “reserved” the payment of tax.

44. In our opinion the claim of the assessee that the sum of Rs. 9,00,000 constituted a reserve within the meaning of R. 2(1) in Sch. II has to be upheld. The learned counsel for the Department referred to certain passages in the Principles of Auditing by F.R.M de Paula in support of his contention, that the provision for taxation would not be a reserve, judged by the principles of sound auditing. That may not be a helpful test to apply, and we, therefore, refrain from examining in detail the passages cited to us. What is accepted as a sound principle of accountancy may not always justify a claim under the Income-tax law, nor can it necessarily decide the issue, whether the claim made by the Assessee in this case that a specified sum constituted a reserve, should be negatived.

45. In our opinion the claim of the assessee that the sum of Rs. 9,00,000, constituted a reserve within the meaning of R. 2(1) of Sch. II should even on the merits prevail. Our answer to the first of the questions referred to this court is that the sum of Rs. 11,00,000, formed part of the company's capital within the meaning of R. 2(1) of Sch. II read with Section 2(1)(a) of the Business Profits Tax Act in respect of the chargeable accounting period 1-4-1946 to 31-12-1946. We answer the second question in the negative and against the assessee. Since neither side has wholly succeeded in its contentions, we make no order as to the costs of this reference.

M.K.S

46. Answer accordingly.