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Hotz Hotels Pvt. Ltd. v. Commissioner Of Income-Tax, Haryana, H.P And Delhi Iii.
Supreme Court Opinion Summary — R.S. Pathak, C.J.
Factual and Procedural Background
The Income-tax Appellate Tribunal, Chandigarh Bench, referred to this Court the following question: whether, on the facts and circumstances, the assessee-company was entitled to include Rs. 2,98,035 shown as "provision for taxation" and Rs. 70,000 shown as "proposed dividends" in the computation of reserves for the purpose of computing the capital used to calculate the standard deduction under the Super Profits Tax Act, 1963.
The assessee is a private limited company. In assessment proceedings under the Super Profits Tax Act, 1963, for the assessment year 1963-64 (previous year Aug 1, 1961 to July 31, 1962), the assessee claimed the two items above as reserves in computing its capital under rule 1 of the Second Schedule to the Act. The Income-tax Officer rejected the claim. The assessee's appeals to the Appellate Assistant Commissioner and then to the Income-tax Appellate Tribunal were unsuccessful, and the Tribunal referred the stated question to this Court.
The statutory context is that the Super Profits Tax Act imposes a special tax on chargeable profits in excess of a "standard deduction." The "standard deduction" equals 6% of the capital computed under the Second Schedule (or Rs. 50,000, whichever is greater). Thus, the correct computation of the company's capital (including what counts as "reserves") directly affects the standard deduction and the resulting super profits tax liability.
Legal Issues Presented
- The referred question (as posed by the Tribunal): "Whether, on the facts and circumstances of the case, the assessee-company is entitled to include Rs. 2,98,035 under the head 'provision for taxation' and Rs. 70,000 being 'proposed dividends' in the computation of reserves, by reference to which the standard deduction is to be computed?"
- Subsidiary, more specific issues implicit in the referral: (a) whether an amount shown as a provision for taxation can be a "reserve" for the purpose of rule 1 of the Second Schedule to the Super Profits Tax Act, and if so to what extent; and (b) whether an amount shown as proposed dividends can be treated as a reserve under the same rule.
Arguments of the Parties
Assessee's Arguments
- The Appellate Tribunal erred in deciding the case by applying provisions of the Companies Act and by concluding that because the two amounts were shown as liabilities in the balance-sheet they could not be treated as reserves for the purposes of the Super Profits Tax Act.
- The term "provision" is not used in the Super Profits Tax Act; therefore, the assessee argued that the Act should not be taken to adopt the accounting label "provision" to exclude the amounts from being treated as reserves. (In short: the assessee urged that accounting terminology in the balance-sheet should not determinatively control the statutory meaning.)
The opinion does not set out any detailed, separate statement of the revenue's pleaded arguments in this reference beyond the Tribunal's and lower authorities' conclusion that the claims were unacceptable; the Court's reasoning recounts and responds to the assessee's submissions.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| Metal Box Company Of India Ltd. v. Workmen [1969] 73 ITR 53 SC | Distinction between a reserve (appropriation of profits retained as capital) and a provision (charge against profits for anticipated losses/liabilities). | The Court cited it to support the general principle that reserves are appropriations for future use while provisions are charges against profits for liabilities or contingencies. |
| Indian Steel and Wire Products Ltd. v. Commissioner of Income-tax [1958] 33 ITR 579 Cal. | Reserve is created and maintained for future application; payments in discharge of present liabilities are expenditure, not reserves. | Used to underline that reserves are set apart for future contingencies and are not payments for present liabilities. |
| Vazir Sultan Tobacco Co. Ltd. v. Commissioner Of Income-Tax, A.P [1974] 96 ITR 248 AP | An amount set aside to provide for a known liability whose amount cannot be determined with substantial accuracy is a provision; an amount set aside not designed to meet a known liability is a reserve. | Applied to explain the commercial-accountancy test distinguishing provisions from reserves in the facts of the present case. |
| Commissioner of Income-tax v. Century Spinning and Manufacturing Co. [1953] 24 ITR 499 SC | To constitute a reserve there must be earmarking — someone with authority must have applied mind and appropriated an amount as a reserve on the relevant date. | Cited to emphasize the requirement of deliberate earmarking/appropriation before an amount can be treated as a reserve. |
| Commissioner of Income-tax v. Standard Vacuum Oil Co. [1966] 59 ITR 685 SC | A reserve admissible in computation of capital need not necessarily be built out of profits; it may be created out of other surpluses. | Used to note that the statutory notion of "reserve" is not confined strictly to profits-derived reserves. |
| Commissioner of Income-tax v. Security Printers of India (P.) Ltd. | (Allahabad High Court decision) Held certain sums representing provisions could be reserves in the particular context of that case. | Court distinguished the decision on its facts: there the revenue did not contend that the amounts represented liabilities already arisen; the present case required closer factual enquiry. |
| Commissioner of Income-tax v. Hind Lamps Ltd. | (Allahabad High Court decision) Sums representing proposed dividends and provision for taxation could not be treated as reserves where the material showed the amounts had been earmarked for payment of dividends or discharge of accrued tax liabilities. | Relied on as an example where clearer material led to the conclusion that the amounts were not reserves; the Court contrasted the factual matrices of the cases. |
Court's Reasoning and Analysis
The Court began by construing rule 1 of the Second Schedule: the capital of a company includes paid-up share capital and reserves (including specially mentioned development rebate reserves and "other reserves" to the extent amounts credited to such other reserves have not been allowed in computing profits under the Income-tax Acts), subject to specified deductions. Thus, to decide whether the two amounts could be included as reserves for computing capital, the Court examined the accounting and legal distinction between a reserve and a provision.
The Court set out established tests drawn from authority and commercial accountancy:
- A "reserve" is an appropriation of profits or surpluses, earmarked for future use, and represented by retained assets forming part of the capital employed.
- A "provision" is a charge against profits to meet an anticipated loss or a known liability whose amount cannot be ascertained with substantial accuracy on the relevant date; provisions reduce profits and are taken against gross receipts in the profit-and-loss account and the balance-sheet.
- There must be clear earmarking or authoritative appropriation on the relevant date for an amount to be a reserve; mere carrying forward of undistributed profits does not make them a reserve.
Applying these principles to the present items:
- Provision for taxation (Rs. 2,98,035): The Court held that so much of such a provision as relates to the discharge of a tax liability that had already arisen on the relevant date cannot be a reserve, because it is earmarked for immediate satisfaction of a pre-existing liability and is therefore not available for future use. It is immaterial that the exact amount was not quantified. However, if the total provision contains an excess over the tax liability already arisen — i.e., an amount intended for future tax liabilities not yet accrued — then that excess could amount to a reserve. The Tribunal had not clarified whether the provision was wholly in respect of an accrued liability or included an excess; the Court therefore remanded that factual question to the Tribunal for investigation and disposal in conformity with this judgment.
- Proposed dividends (Rs. 70,000): The Court examined the documented treatment. The directors had recommended the dividend and shareholders accepted the recommendation in general meeting by the relevant date; thus, the amount had been earmarked for payment. Because the amount was specifically set apart to satisfy a dividend recommendation and accepted by shareholders, it was not available for future use by the company and therefore did not represent a reserve. The Court added that if, contrary to the record, the directors had not made the recommendation by the relevant date, then the sum would have been an undistributed mass of profits — not a reserve because no-one with authority had applied their mind to appropriate it as a reserve. In either factual variant, the Rs. 70,000 did not qualify as a reserve.
The Court also addressed the assessee's submissions:
- On reliance upon the Companies Act and the form of the balance-sheet: the Court held that, for the purpose of determining the assessee's intention and conduct (a question of fact), it was legitimate to consider how the amounts were shown in the balance-sheet and the surrounding material; those features are relevant evidence of earmarking or the absence of it.
- On the contention that the Super Profits Tax Act does not use the word "provision": the Court accepted that "provision" is an accounting term but considered it permissible to use the commercial-accountancy distinction between provisions and reserves when construing the statutory phrase "reserve" in rule 1. Accordingly, the Court held that the provision for taxation could be treated as a reserve only to the extent that it exceeded accrued tax liability as at the relevant date.
Procedurally, because the Tribunal had not made the necessary factual findings about whether part of the provision exceeded accrued liability, the Court remitted that factual issue to the Tribunal for determination consistent with the legal guidance provided.
Holding and Implications
Holding:
The sum shown as "provision for taxation" (Rs. 2,98,035) may be treated as a reserve only to the extent that it exceeds the tax liability which had already arisen on the relevant date; the amount shown as "proposed dividends" (Rs. 70,000) cannot be treated as a reserve.
Implications:
- Direct effect on the parties: The Tribunal must enquire and determine whether any part of the Rs. 2,98,035 provision represented an amount in excess of the tax liability already accrued on August 1, 1961; if so, that excess may be included as a reserve when computing capital for the standard deduction. The Rs. 70,000 for proposed dividends is not includible as a reserve.
- The decision requires remand to the Tribunal for factual determination on the composition of the provision for taxation and for further disposal conformably with this judgment.
- The opinion does not state broader policy consequences beyond resolving the referred question and ordering the factual enquiry; it does not assert that it establishes any novel legal principle beyond applying existing tests distinguishing provisions and reserves and applying them to the facts before the Court.
Final procedural note from the opinion: "The question referred is answered accordingly." There was no order as to costs.
R.S Pathak, C.J:— The Income-tax Appellate Tribunal, Chandigarh Bench, has referred the following question for the opinion of this court:
“Whether, on the facts and circumstances of the case, the assessee-company is entitled to include Rs. 2,98,035 under the head ‘provision for taxation’ and Rs. 70,000 being ‘proposed dividends’ in the computation of reserves, by reference to which the standard deduction is to be computed?”
2. The assessee is a private limited company. In assessment proceedings under the Super Profits Tax Act, 1963, for the assessment year 1963-64, (for which the relevant previous year commenced on August 1, 1961, and ended on July 31, 1962), the assessee claimed the following two items as reserves in the computation of its capital under rule 1 of the Second Schedule to the Act:
Rs. P. 1. Provision for taxation as on the first day of the previous year, i.e, August 1, 1961 … 2,98,035.00 2. Proposed dividends … 70,000.00
3. The Income-tax Officer rejected the claim of the assessee. An appeal by the assessee before the Appellate Assistant Commissioner and a second appeal before the Income-tax Appellate Tribunal did not succeed. It was affirmed that the claim was unacceptable. And now, at the instance of the assessee, the present reference has been made. The Super Profits Tax Act, 1963, charges a special tax on the amount by which the chargeable profits of a company during a previous year or years exceed the standard deduction. The standard deduction is an amount equal to 6 per cent, of the capital of the company computed in accordance with the provisions of the Second Schedule or an amount of Rs. 50,000, whichever is greater. The computation of the capital of the company is therefore, involved in determining the amount of the “standard deduction” and this in turn affects the determination of the super profits tax.
4. Rule 1 of the Second Schedule provides:
“Subject to the other provisions contained in this Schedule, the capital of a company shall be the sum of the amounts, as on the first day of the previous year relevant to the assessment year, of its paid up share capital and of its reserve, if any, created under the proviso (b) to clause (vib) of sub-section (2) of section 10 of the Indian Income-tax Act, 1922 (11 of 1922) or under sub-section (3) of section 34 of the Income-tax Act, 1961 (43 of 1961), and of its other reserves in so far as the amounts credited to such other reserves have not been allowed in computing its profits for the purposes of the Indian Income-tax Act, 1922 (11 of 1922), or the Income-tax Act, 1961 (43 of 1961), diminished by the amount by which the cost to it of the assets the income from which in accordance with clause (iii) or clause (vi) or clause (vii) of rule 1 of the First Schedule is not includible in its chargeable profits, exceeds the aggregate of—
(i) any money borrowed by it which remains outstanding; and
(ii) the amount of any fund, any surplus and any such reserve as is not to be taken into account in computing the capital under this rule.”
5. Broadly speaking, the capital of the company includes its paid up share capital and its reserves. One kind of reserve is specifically mentioned in rule 1, and that is the development rebate reserve created under proviso (b) to section 10(2)(vib) of the Indian Income-tax Act, 1922, or subsection (3) of section 34 of the Income-tax Act, 1961. Rule 1 also speaks of “other reserves”.
6. It is now well-settled that a reserve is an amount set apart or appropriated for some future use. The distinction between a reserve and a provision is well-known in commercial accountancy. Provisions made against anticipated losses and contingencies are charges against profits and are, therefore, taken into account against gross receipts in the profit and loss account and the balance-sheet. Reserves, on the other hand, are appropriations of profits, the assets by which they are represented being retained to form part of the capital employed in the business: Metal Box Company Of India Ltd. v. Workmen [1969] 73 ITR 53 SC.. To constitute a provision, it must be in respect of a known liability, of which the amount cannot be determined with substantial accuracy on the relevant date. If the liability is not known on that date and an amount is appropriated or set apart for a future use, a reserve is said to be created. A reserve is created and maintainted for the purpose of being drawn upon in future. If certain payments are to be made in discharge of a present liability in the course of the year to which the balance-sheet and the profit and loss account relate, such payments cannot be treated as a reserve but are of the nature of expenditure. A reserve is created out of the whole or part of the surpluses and is found in the hands of the company at the end of the year and it is reserved for application in a contingency which still lies in the future: Indian Steel and Wire Products Ltd. v. Commissioner of Income-tax [1958] 33 ITR 579 Cal.. It has been observed that an amount set aside out of profits and other surpluses to provide for any known liability of which the amount cannot be determined with substantial accuracy is a provision, while an amount set aside from profits and other surpluses and not designed to meet a liability, contingency, commitment or diminution in the value of assets known to exist at the date of the balance-sheet is a reserve: Vazir Sultan Tobacco Co. Ltd. v. Commissioner Of Income-Tax, A.P [1974] 96 ITR 248 AP..
7. It is also necessary, in order to constitute a reserve, that the amount should not remain a mere undistributed mass of profits but should be earmarked as a reserve. If it is not earmarked as a reserve and is carried forward to the next accounting year it remains an undistributed mass of profits and cannot be described as a reserve. Someone with authority must on the relevant date have applied his mind to the question of creating a reserve out of the profits or other surpluses and set apart an amount as a reserve. There must be clear indication that it has been made or declared a reserve: Commissioner of Income-tax v. Century Spinning and Manufacturing Co. [1953] 24 ITR 499 SC. It is not necessary that a reserve admissible in the computation of capital should be one built out of profits: it may be created out of other surpluses also: Commissioner of Income-tax v. Standard Vacuum Oil Co. [1966] 59 ITR 685 SC. These constitute generally the tests on the basis of which it falls to be decided whether an amount can be treated as a reserve or not.
8. We have before us two items for consideration, provision for taxation and proposed dividends. In the case of provision for taxation, so much of that provision as relates to the discharge of tax liability which has already arisen, whether it has been quantified or not under the relevant statute, cannot be considered as reserve. To that extent it has been earmarked for payment in satisfaction of the tax liability; it is not available to the assessee for future use. It is immaterial that the exact amount of the tax liability is not known on the date when the provision for taxation was made; it is sufficient that the tax liability has accrued.
9. If, however, the total amount of Rs. 2,98,035 includes an amount in excess of that contemplated for the discharge of a tax liability which has already arisen and the excess is intended for use in the future against a tax liability which has yet to arise, to the extent of the excess it may be said that a reserve has been created. The Tribunal has been unable to specifically state whether the provision of Rs. 2,98,035 for taxation has been earmarked for the discharge of a tax liability, which has already arisen on August 1, 1961, the relevant date under rule 1 of the Second Schedule, and a supplementary statement of the case submitted by it does not make the position clear. Apparently, when the appeal was heard before the Tribunal its attention was not drawn to the need for an investigation into this aspect of the case. It will now be for the Tribunal, when the case goes back to it for disposing of conformably with this judgment, to look into this matter.
10. As regards the amount of Rs. 70,000 shown as proposed dividends, it appears clear that on the relevant date the amount had been earmarked for the payment of dividends. The dividend was recommended by the directors of the assessee and the supplementary statement shows that the recommendation in fact was accepted by the shareholders in general meeting. On the date when the provision was made for proposed dividends, it must be presumed that the directors expected that the recommendation in respect of dividends would be accepted by the shareholders. It was in that expectation that they earmarked the amount towards the proposed dividends. The amount was set apart for a specific purpose: it was not set apart for future use by the assessee. If the recommendation of the directors was not made by August 1, 1961, then the position is that the amount of Rs. 70,000 was still part of an undistributed mass of profits. It had not been set apart or appropriated as a reserve. On that date it cannot be said that any one with the requisite authority had applied his mind and decided that the amount of Rs. 70,000 should be set apart or appropriated from the profits and turned into a reserve for future use. Whichever way one looks at it the amount certainly does not represent a reserve.
11. Our attention has been drawn to Commissioner of Income-tax v. Security Printers of India (P.) Ltd., in which the Allahabad High Court appears to have held that certain sums representing provision for bonus, provision for taxation and provision for proposed dividends were reserves. It is necessary to point out, however, that in taking that view the court specifically observed that it was never the case of the revenue that the amounts represented liabilities which had already arisen and were not intended for future use in a future contingency. It is in that context that the decision in that case has to be appreciated. Subsequently, in Commissioner of Income-tax v. Hind Lamps Ltd., the same court held that sums representing proposed dividends and provision for taxation could not be treated as reserves because the material on the record indicated clearly that the amounts had been earmarked, the one for payment of the dividend, and the other for the discharge of a tax liability which had already accrued and merely awaited quantification from by assessment. The qualitative difference in the material available in the latter case led to a decision different that in the former case.
12. It was urged for the assessee that the Appellate Tribunal erred in deciding the case on the basis of the provisions of the Companies Act, and in proceeding on the footing that because the two amounts under consideration were shown as liabilities in the balance-sheet they could not be treated as reserves for the purpose of the Super Profits Tax Act. It was submitted that the expression employed in the Super Profits Tax Act should not be construed by reference to the Companies Act. Now, there can be no dispute that for the purpose of determining what the assessee had in mind, and that is a question of fact, it would be pertinent to consider all relevant material on the point. The manner in which the amounts have been shown in the balance sheet furnish that material. Therefore, for the purpose of determining the state of mind and the conduct of the assessee in respect of the two amounts in question there is justification for examining how the two amounts were treated by the assessee.
13. It is also urged for the assessee that as the expression “provision” has not been used in the Super Profits Tax Act, it should not be taken into account in disposing of this reference. The expression “provision” is a well-known expression in commercial accountancy, and may legitimately be employed in this case for the purpose of drawing a distinction from the expression “reserve”. In our opinion, the amount of Rs. 2,98,035 shown as provision for taxation can be treated as a reserve only to the extent that it exceeds the tax liability which had already arisen on August 1, 1961. It will be for the Appellate Tribunal to enquire into this aspect of the case when disposing it of conformably with this judgment. As regards the amount of Rs. 70,000 shown on account of proposed dividends, this amount cannot be treated as a reserve.
14. The question referred is answered accordingly.
15. In the circumstances of the case, there is no order as to costs.
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