The Judgment of the Court was delivered by

Dipak Kumar Sen, J.:— M/s. Peico Electronics & Electricals Ltd., the assessee, an existing company within the meaning of the Companies Act, 1956, was assessed to surtax under the Companies (Profits) Surtax Act, 1964, in the assessment year 1974-75. The relevant accounting year ended on December 31, 1973.

2. Under the Surtax Act, the Income-tax Officer was required to compute the capital of the assessee as on January 1, 1973. In computing the capital of the assessee, the Income-tax Officer excluded a sum of Rs. 19,36,835 on account of deduction allowed to the assessee under section 80J of the Income-tax Act. The Income-tax Officer also excluded a sum of Rs. 50 lakhs which appeared in the balance-sheet of the assessee as a debenture redemption reserve. Being aggrieved, the assessee preferred an appeal to the Appellate Assistant Commissioner. The Appellate Assistant Commissioner considered and construed the Explanation to rule 1 of Schedule II to the Surtax Act and held that a sinking fund should be excluded from the computation of capital for the purpose of surtax. He found that the debenture redemption reserve in the case of the assessee had not been invested as was required to create a sinking fund and, therefore, the same did not constitute a sinking fund. He held that the same should not be excluded in computing the capital base of the assessee for the purposes of surtax.

3. Following the decision of the Karnataka High Court in the case of Stumpp, Schuele & Somappa Pvt. Ltd., [1976] 102 ITR 320, the Appellate Assistant Commissioner held that the Income-tax Officer was also not justified in reducing the capital base of the assessee by Rs. 19,36,835 on the ground of deduction allowed to the assessee under section 80J of the Income-tax Act, 1961, under rule 4 of the Second Schedule to the Surtax Act. The appeal of the assessee was allowed accordingly.

4. Being aggrieved, the Revenue preferred an appeal from the decision of the Appellate Assistant Commissioner to the Income-tax Appellate Tribunal. The Tribunal noted that the facts as found and considered by the Appellate Assistant Commissioner remained undisputed. The Tribunal noted that the debenture redemption reserve was not invested in any shares or securities but was utilised for the purpose of the assessee's business. The Tribunal held that the said reserve could not be considered as a sinking fund to be excluded from the capital base of the assessee by reason of the Explanation to rule 1 of the Second Schedule to the Surtax Act. The Tribunal in arriving at the said decision considered and applied the principles of accountancy from the standard text book on Accountancy by William Pickles, 3rd edition.

5. The Tribunal also held, following several decisions of High Courts, that the Income-tax Officer was also not justified in reducing the capital base of the assessee by Rs. 19,36,835 on account of deduction allowed to the assessee under section 80J of the the Income-tax Act, 1961.

6. On an application of the Revenue under section 256(1) of the Income-tax Act, 1961, the following questions have been referred as questions of law arising out of the order of the Tribunal, for the opinion of this court:

“1. Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the debenture redemption reserve of Rs. 50,00,000 should not be excluded from the capital base?

2. Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the capital base cannot be reduced proportionately with reference to the deductions allowed under section 80J of the Income-tax Act, 1961, under rule 4 of the Second Schedule to the Companies (Profits) Surtax Act, 1964?”

7. The controversy raised in question No. 2 is covered by the decision of this court in CIT v. Schrader Scovill Duncan Ltd., [1981] 132 ITR 822.

8. Following the said decision, we answer the question in the affirmative and in favour of the assessee.

9. On question No. 1, the learned advocate for the Revenue submitted that whether the said sum of Rs. 50 lakhs shown as debenture redemption reserve amounted to a sinking fund or not was not relevant as, in any event, the said amount could not be treated as a reserve for the purpose of the Surtax Act inasmuch as the same was a provision made for meeting a liability arising on account of redemption of the debentures of the assessee. The liability was known and ascertained and the assessee had provided for meeting the same by setting up a fund.

10. The learned advocate for the Revenue also contended that though in the instant case the said sum Rs. 50 lakhs had been described as a debenture redemption reserve, it should be treated or deemed to be a sinking fund as the same had been created for meeting a liability.

11. In support of his contentions, the learned advocate for the Revenue cited the following decisions.

(a) CIT v. Calcutta Electric Supply Corporation Ltd., [1982] 138 ITR 111 (Cal). In this case, the question referred to this court was whether a debenture sinking fund constituted a reserve for the purpose of computation of capital of the assessee under the Second Schedule to the Super Profits Tax Act, 1963. A Division Bench of this court considered the principles of accountancy involved and in particular noted the following (at page 119):

(i) Spicer & Pegler's Book Keeping and Accounts, 17th edn., under section 10 (page 66). “Section 10. The operation of Sinking Funds for the Repayment of Loans. —A sinking fund for the repayment of a loan is created in a manner similar to the depreciation fund for the replacement of an asset, described in section 8(d) (page 57) except that the annual provision is an appropriation of, and not a charge against, profit. Equal amounts are debited to the Appropriation Account each year and credited to Sinking Fund Account, an equivalent sum is invested outside the business in securities (cash being credited and investments debited) and allowed to accumulate at compound interest, so as to produce the amount required to repay the loan on its due date”… In the case of a sinking fund for the repayment of a loan, the net assets are increased by the amount of the fund; a depreciation fund merely maintains the net assets at their original book value… The balances in the profit and loss account and the Sinking Fund Account are both reserves which form part of the proprietors' interest in the net assets of the undertaking (at page 120).”

(ii) Batliboi, Advanced Accountancy, 27th edition, p. 678 (at p. 120); “Sinking Fund. —A Sinking Fund is a fund created with the object of providing means for the redemption of liabilities like debentures or any other loan. It is formed by setting aside, half yearly or yearly, a fixed sum of money for a definite period, such sum to be invested at compound interest, so that at the end of the period the annual amounts, with accumulations of interest, will be sufficient to discharge a prescribed loan. In such a case, the amount set aside should not be debited to Revenue Account but to a Net Revenue Account or Profit and Loss Appropriation Account, as being rather in the nature of an allocation of profits than a charge against them.”

The court observed as follows (at page 121):

“It would be clearly seen from the above that the essence of distinction between a Reserve Fund and a Sinking Fund lies in this, that whereas a Reserve Fund is maintained as a measure of prudence, and the amount representing it may or may not be invested in outside securities as may be found financially desirable, a Sinking Fund, being created to meet a known liability at a definite future date, should always be invested outside the business.”

On a consideration of several decisions of this court, other High Courts and also the Supreme Court, it was held that a debenture sinking fund constituted a reserve for the purpose of computation of capital under the Super Profits Tax Act, 1963.

(b) Commissioner Of Income-Tax v. National Rayon Corporation Ltd., [1986] 160 ITR 716 (Bom). In this case, the question before the Bombay High Court was whether a sum representing a debenture redemption reserve was includible in computing the capital of the assessee under rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964. The Bombay High Court found that the debenture concerned had become redeemable in the year of assessment but in fact none of the debentures had been redeemed. A Division Bench of the Bombay High Court held as follows (at page 721):

“… it clearly appears to us that the debenture redemption reserve must be regarded as a provision made by the assessee company to enable it to redeem the said debentures when they became due for redemption. Since the aggregate amount of such debentures is much larger than the amount of the debenture redemption reserve, we fail to see how it can be said that there was any excess as such in this appropriation which could be taken as reserve. It is true that all the debentures had not become redeemable during the relevant previous years, but that does not make any difference because an amount set aside to meet a future liability, which was certain to come into existence as in this case, must be regarded as a provision and not as a reserve.”

(c) CIT v. Sijua (Jharriah) Electric Supply Co. Ltd., [1986] 150 ITR 332 (Cal). In this case, the question before a Division Bench of this court was whether a reserve for debenture redemption should be taken into account for the computation of capital under the Second Schedule to the Surtax Act. It was found as a fact that according to the terms of issue of the debentures, the assessee company was required to redeem 60 debentures of the total value of Rs. 60,000 every year and had credited each year an amount of Rs. 60,000 to the debenture redemption account. As the debenture trust deed was not before the court, it could not be ascertained whether there was any scientific basis of payment of Rs. 60,000 every year to the debentureholders and whether any excess provision had been made every year. Unable to decide the controversy, the court remanded the matter to the Tribunal to be decided in the light of the principles laid down by the Supreme Court in Vazir Sultan Tobacco Co. Ltd. v. CIT, [1981] 132 ITR 559.

12. The learned advocate for the assessee contended, on the other hand, that in the instant case, Rs. 50 lakhs constituting the debenture redemption reserve fulfilled all the tests of a reserve and was not a provision. He produced a copy of the balance-sheet of the assessee for the relevant assessment year. The same was not included in the statement of the case. We allowed the assessee to rely on the balance-sheet inasmuch as the same formed a part of its return and as there was no objection from the revenue. It appeared from the said balance-sheet that after calculating the profits and after payment of and provision made for taxation and other expenditure, a sum of Rs. 10 lakhs had been carried over to the debenture redemption reserve. The debenture stock was shown as part of the shareholder's interest and the dividend redemption reserve was shown as part of the entire reserves of the company. It also appeared from the balance-sheet that the debenture stock in the instant case was for the periods 1977 to 1982 and the same were redeemable at par on December 31, 1982, commencing from December 31, 1978.

13. The learned advocate for the assessee submitted that the debenture redemption reserve was created not by way of a charge on the revenue but by way of appropriation from the profits of the assessee. He submitted further that the said reserve formed part of the working capital of the assessee and no sinking fund had been created with the said fund whereby the amount was invested outside the business of the assessee. The said fund was not part of the undistributed profits but had been set apart ‘specifically for future use. It was submitted that the said fund has been rightly treated as part of the reserves of the assessee. It was also submitted that it has been found by the authorities below that the amount constituting the said reserve had not been invested outside the business of the assessee and as such could not be held or treated to be a sinking fund. The liability for the debenture stock, it was submitted, had been separately shown in the balance-sheet of the assessee and, therefore, there could not be any necessity or reason for making a separate provision for the same liability. In support of his contentions, the learned advocate for the assessee cited Pickles' Accountancy, 3rd edition, page 186, where it is stated that a provision could be made in the accounts for an estimated and undisputed liability which existed at the date of the balance-sheet.

14. It was submitted that if this test was applied, the debenture redemption reserve could not be treated as a provision as there was no liability to redeem any of the debentures in the year in question and there was no existing liability in the year involved.

15. In support of his contentions, the learned advocate for the assessee cited Vazir Sultan Tobacco Co. Ltd. v. CIT, [1981] 132 ITR 559 (SC). In this case, the Supreme Court considered its own earlier decision as also the decisions of various High Courts and held, inter alia, that a provision made for payment of dividends would not be treated as a reserve. The Supreme Court quoted with approval observations from its earlier judgment in Metal Box Company oj India Ltd., [1969] 73 ITR 53 as follows ([1981] 132 ITR at page 569):

“The distinction between a provision and a reserve is in commercial accountancy fairly well known. Provisions made against anticipated losses and contingencies are charges against profits and, therefore, to be taken into account against gross receipts in the P & L Account and the balance-sheet. On the other hand, reserves are appropriations of profits, the assets by which they are represented being retained to form part of the capital employed in the business. Provisions are usually shown in the balance-sheet by way of deductions from the assets in respect of which they are made whereas general reserves and reserve funds are shown as part of the proprietor's interest… the broad distinction between the two is that whereas a provision is a charge against the profits to be taken into account against gross receipts in the P & L account, a reserve is an appropriation of profits, the asset or assets by which it is represented being retained to form part of the capital employed in the business.”

16. Considering its earlier decision in the case of Century Spinning and Manufacturing Company Ltd., [1953] 24 ITR 499 (SC), it was observed as follows ([1981] 132 ITR at page 581):

“… the true nature and character of the appropriation must be determined with reference to the substance of the matter; obviously this means that one must have regard to the intention with which and the purpose for which appropriation has been made, such intention and purpose being gathered from the surrounding circumstances. In that behalf, the following aspects mentioned in the judgment provide some guidelines: (a) a mass of undistributed profits cannot automatically become a reserve and that somebody possessing the requisite authority must clearly indicate that a portion thereof has been earmarked or separated from the general mass of profits with a view to constituting it either a general reserve or a specific reserve, (b) the surrounding circumstances should make it 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 occasion, and (c) a clear conduct on the part of the directors in setting apart a sum from out of the mass of undistributed profits avowedly for the purpose of distribution as dividend in the same year would run counter to any intention of making that amount a reserve.”

17. Considering another earlier decision of the Supreme Court in CIT v. Standard Vacuum Oil Co., [1966] 59 ITR 685, it was observed as follows ([1981] 132 ITR at pages 582, 583):

“In the first place, the nomenclature accorded to any particular fund which is set apart from out of the profits would not be material or decisive of the matter and, secondly, having regard to the purpose of rule 2 of Schedule II of the Business Profits Tax Act, 1947, if any amount set apart from out of the profits is going to make up the capital fund of the assessee and would be available to the assessee for its business purposes, it would become a reserve liable to be included in the capital computation of the assessee under that Act.”

18. In the facts of the case, it was held that though the directors had only recommended a dividend and no dividend had been declared, the circumstance, that the amount appropriated was set apart to pay the dividends in the same year, was contrary to any intention that the said amount would be treated as a reserve.

19. Learned advocate for the assessee also relied on the decision of this court in Calcutta Electric Supply Company Ltd., [1982] 138 ITR 111, where it was held that a debenture sinking fund was a reserve.

20. The learned advocate for the assessee submitted that in the case of National Rayon Corpn. Ltd., [1986] 160 ITR 716, before the Bombay High Court, it was found as a fact that the debentures had become payable in the year involved. He submitted that the Bombay High Court did not have occasion to consider the principles of accountancy. He further submitted that on a correct application of the decision of the Supreme Court in Vazir Sultan Tobacco Co. Ltd., [1981] 132 ITR 559, a debenture redemption reserve made in respect of debentures not redeemable during the relevant previous year should not be considered to be a provision.

21. On a consideration of the facts of this case, the respective submissions of the parties and the decisions cited before us, it appears that the debenture redemption fund in the instant case fulfills the tests of a reserve in more than one way; (a) the reserve has been created in the instant case out of appropriation from profits and not by way of a charge on the revenue; (b) the fund has been retained to form part of the capital employed in the business, i.e, it has not been invested in securities or otherwise so as to take it out of the business; (c) in the instant case, none of the debentures became redeemable during the accounting period. The liability to redeem the debentures was a future liability, and (d) the debentures had been separately shown in the balance-sheet as a liability.

22. It appears to us that the debenture not being redeemable in the relevant accounting year, the assessee was not obliged to make any provision therefor. Even if the fund is treated as a provision, the amount in the said fund for the relevant accounting year was in excess of the amount which would be reasonably necessary to meet any liability and in the year involved, the entire fund should be held to be an excess and treated as reserve.

23. On a construction of a similar statute, namely, the Super Profits Tax Act, 1963, this court, in Calcutta Electric Supply Corporation Ltd., [1982] 138 ITR 111, held/that a debenture sinking fund constituted a reserve and had to be included in the capital base of the assessee for the purpose of computation of super profits under the said statute. In the instant case, we are concerned with the Companies (Profits) Surtax Act, 1964, an Act similar to the Super Profits Tax Act, 1963. The only difference is the Explanation which is added to rule 1 of the Second Schedule to the Surtax Act by which a sinking fund has been specifically directed not to be treated as a reserve for the purpose of computation of capital. It has been found in this case that the debenture redemption reserve has not been converted into a sinking fund by investment as recognised by the principles of accountancy. We have no reason to hold otherwise.

24. With respecct, we are unable to agree with the view taken by the Bombay High Court in National Rayon Corporation Ltd., [1986] 160 ITR 716, which in any event is distinguishable on facts. For the above reasons, we accept the contention of the assessee and answer question No. 1 in the affirmative and in favour of the assessee.

25. There will be no order as to costs.

Monjula Bose, J.:— I agree.