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Commissioner Of Income Tax, Kanpur v. Saran Engineering Co. Ltd. .
Factual and Procedural Background
The judgment consolidates three matters—Civil Appeal No. 1546 of 1974, Civil Appeal No. 1599 of 1974, and Special Leave Petition (SLP) No. 4815-A of 1977—all arising out of assessments under the Super Profits Tax Act, 1963 (and, in the SLP, the Companies (Profits) Surtax Act, 1964). Each proceeding concerns whether specific credit balances—described by the assessees as reserves—should be included in the “capital” of the company as computed under the Second Schedule of the 1963 Act (or the parallel schedule of the 1964 Act) for the purpose of the statutory 6 % standard deduction.
In each case:
- The Income-tax authorities excluded some or all of the disputed balances from the capital base.
- The Appellate Assistant Commissioners and the Income-tax Appellate Tribunals took divergent views, partly allowing the assessees’ claims.
- The High Courts, on references under Section 256(1)/256(2) of the Income-tax Act, either accepted or rejected the Tribunal findings in part.
- The aggrieved parties appealed to the Supreme Court (or sought special leave) on questions limited to whether the amounts constituted “reserves” or “provisions”.
Legal Issues Presented
- Whether the following specific credit balances constitute “reserves” within the meaning of Rule 1 of the Second Schedule to the Super Profits Tax Act, 1963, and are therefore includible in the computation of a company’s capital:
- Capital reserve
- Stocks and stores (or stores) reserve
- Bad and doubtful debts reserve
- Obsolescence reserve
- Loans and insurance reserve
- Investment reserve
- Rehabilitation reserve
- Forfeited moneys reserve
- Gratuity reserve, reserve for special survey, reserve for contingencies, fleet-replacement reserve, reserve for exempted profits under Section 84, reserve for investment depreciation, and dividend equalisation reserve
- What test distinguishes an allowable “reserve” from a mere “provision” earmarked for an existing liability.
Arguments of the Parties
Assessee’s Arguments
- Amounts were transferred from Profit & Loss Appropriation Accounts or derived from capital profits; hence they are not charges against current profits but discretionary appropriations, qualifying as “reserves”.
- In the case of the Bad and Doubtful Debts Reserve, a separate specific provision had already been made; the impugned balance therefore exceeded any reasonably anticipated liability and should be treated as a free reserve.
- Several reserves (e.g., stocks and stores, rehabilitation, contingencies) were created merely to safeguard against possible future losses and were not earmarked against any present enforceable obligation.
Revenue’s Arguments
- The nomenclature “reserve” is not decisive; if the amount is set aside to meet an existing or clearly foreseen liability, it is a “provision” and must be excluded from capital.
- Items such as obsolescence reserve and forfeited moneys reserve represent either provisions for asset-write-off or obligations to shareholders/creditors and therefore cannot inflate the capital base.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| CIT v. Elgin Mills Ltd. (1986) 3 SCC 655 | Capital profits standing to credit of “capital reserve” constitute a reserve unless earmarked for an existing liability. | Relied upon to uphold inclusion of the capital reserve in the assessee’s capital base. |
| CIT v. British India Corporation Ltd. (1986) 3 SCC 655 | Clarified the distinction between a “reserve” and a “provision” under the Super Profits Tax Act. | Used as controlling authority for classifying each disputed item; specifically followed for stocks and stores reserve, rehabilitation reserve, and bad-debt reserve. |
| Civil Appeal No. 1665 of 1974 (1986) 3 SCC 655 | Re-affirmation of earlier Supreme Court principles on reserves under the Companies (Profits) Surtax Act. | Cited in the SLP to dismiss the plea for a further reference; held that the High Court correctly applied settled law. |
Court's Reasoning and Analysis
The Court applied a uniform two-step analysis:
- Identify whether the balance was earmarked to meet an existing, ascertained, or reasonably anticipated liability on the first day of the accounting year. If so, it is a “provision” and excluded.
- If the amount was a discretionary appropriation of profits or capital surplus, free from any present obligation, it qualifies as “other reserve” and is to be included in capital.
Applying this test, the Court held:
- Included as reserves: capital reserve (derived from insurance claim and prior profit transfers), stocks and stores reserve, bad and doubtful debts reserve (excess over specific provision), loans and insurance reserve, investment reserve, rehabilitation reserve, stores reserve (in Civil Appeal 1599), gratuity, special survey, contingencies, fleet-replacement, section 84 exempted profits, investment depreciation, and dividend-equalisation reserves (in the SLP).
- Excluded: obsolescence reserve (treated as provision for future write-offs) and forfeited moneys reserve (not a free reserve).
The Court noted that even where the quantum of a future liability is uncertain, a fund created merely as a cushion and not against an accrued liability remains a reserve. Conversely, amounts set aside for a liability already arisen—even if the exact figure is unknown—are provisions.
Holding and Implications
HOLDING: All appeals and the special-leave petition were DISMISSED, save that the Supreme Court directed exclusion of the obsolescence reserve (Civil Appeal 1546/1974) and confirmed the High Courts’ refusal to treat forfeited moneys reserve as a reserve.
Implications: The decision reaffirms the Supreme Court’s established test distinguishing reserves from provisions for the purpose of computing capital under the Super Profits Tax Act, 1963, and the Companies (Profits) Surtax Act, 1964. While it clarifies the treatment of several common reserve categories, it does not create new legal doctrine; rather, it consolidates existing principles and upholds the High Courts’ applications thereof.
Sabyasachi Mukharji, J.— In Civil Appeal No. 1546 of 1974 the following items were involved: (a) capital reserve, (b) stocks and stores reserves, (c) bad and doubtful debts reserves, (d) obsolescence reserve, (e) loans and insurance reserve, (f) investment reserve and (g) forfeited moneys reserves. The question was whether these were to be included in the computation of capital according to the provisions in the Second Schedule to the Super Profits Tax Act, 1963.
2. Under Section 4 of the Super Profits Tax Act, 1963, every company shall be charged for every assessment year commencing from April 1, 1963 a tax as super profits tax in respect of so much of its chargeable profits of the previous year as exceed the standard deductions at the rate or rates specified in the Third Schedule. “Standard deduction” had been defined in clause (9) of Section 2 as follows:
“An amount equal to 6 per cent of the capital of the company as computed in accordance with the provisions of the Second Schedule, or an amount of Rs 50,000, whichever is greater.”
3. The Second Schedule contained rules for computation of capital of a company for the purpose of the said Act.
4. None of the reserves claimed by the assessee had been allowed as deductions in the computation of its profits under the relevant Income Tax Act. The question was whether these represented reserves.
5. The Tribunal has referred to this Court the following question:
“Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that: (a) capital reserve, (b) stocks and stores reserves, (c) bad and doubtful debts reserve, (d) obsolescence reserve, (e) loans and insurance reserves, (f) investment reserve and (g) forfeited moneys reserves were to be included in the computation of capital according to the provisions in the Second Schedule to the Super Profits Tax Act, 1963?”
6. We must observe that so far as the capital reserves are concerned, in view of the findings recorded by the High Court that the amount represented reserve and it was not earmarked for any existing liability for being utilised by the company, it must be held to be reserve.
7. The capital reserve which was a sum of Rs 11,73,952 consisted of two amounts, namely, Rs 12,212 and Rs 11,61,770. The amount of Rs 12,212 represented an insurance claim received by the assessee Company on account of a fire which had destroyed some assets of the assessee Company. The said receipt of fire insurance claim has directly been credited to the capital account and the sum of Rs 11,61,770 was credited by transfer from the Profit & Loss Account in the earlier years. This was not provided for against any existing or future liability. It was rightly treated as capital reserve.
8. The next item was stocks and stores reserve. This was created in 1950 by transfer from the Profit & Loss Appropriation Account. This did not represent any existing provision for existing liability to meet any specific contingency for safeguarding against diminution of the value of the stocks and stores. It was in the nature of a reserve for safeguarding against any possible diminution of the value of stocks and stores on any future occasion. In our opinion, the Tribunal was right in treating it as reserve.
9. Bad and doubtful debts reserve was created in 1956 through the Profit & Loss Appropriation Account. The amount involved was Rs 5,00,000. It was submitted on behalf of the assessee by Shri Salve that this was created by transfer from the Appropriation Account and not a charge against profit. Furthermore, a separate provision was made for bad and doubtful debts which provision was reduced from the value of the assets. It was not the revenue's case that the provision for bad and doubtful debts provided was less than the amount reasonably necessary to be provided. If the amount as it appears to be is more than the amount reasonably necessary to be provided in respect of bad and doubtful debts then it constituted a “reserve”. It is not correct to state that by very nomenclature this was not a reserve. True nature of the transaction has to be examined.
10. The next item is obsolescence reserve of Rs 1,72,259. This was created in 1959 by transferring a sum of Rs 12,05,000 from the Profit & Loss Account. Some amounts were written off out of this reserve in 1960 and 1961. This appears to be a provision to meet future liability and contingency. But there are not much facts about it. Had it been necessary we might have remanded the matter to the High Court to direct the Tribunal to find facts on this aspect. But as in that view of the matter, this item was not pressed before us, so this item is deleted from reserve of the assessee.
11. So far as loan and insurance reserve is concerned, this was created prior to 1947. It was found that it was free from any burden and it was not utilised for any purpose and was transferred to the General Reserve Account in 1963. Therefore, it was rightly treated, in view of the principles mentioned hereinbefore as reserve.
12. The next item is investment reserve. This fund was created out of the surplus on the sale of investment which was not held by the respondent Company as its stock-in-trade. The surplus did not have its origin in business profits and was transferred directly to the reserve account but this was created prior to 1954 and was further credited in 1955 to 1957 out of the profits on sale of investments. In the later years, whenever a loss of a capital nature was incurred it was debited to this account. It appears that at the time of creating this reserve, the Directors could not have possibly anticipated the losses which might occur in future but merely created a reserve so that losses which do normally arise in the course of business might be adjusted against this amount. It appears therefore that this was a reserve created out of the capital profits. This reserve can rightly be treated as other reserves.
13. Forfeited moneys reserve, in our opinion, cannot be treated as reserve, and the High Court has also not treated it as such. In that view of the matter except the item indicated as obsolescence reserve which is deleted from the reserve as indicated before, we uphold the order of the High Court. This appeal is dismissed subject to the extent indicated above. There will be no order as to costs.
14. In Civil Appeal No. 1599 of 1974, the following facts were recorded:
“The assessee is a limited company. In proceedings under the Super Profits Tax Act, 1963, the assessee claimed that the following amounts appearing as credit balances in the various accounts mentioned against each be treated as reserves and included in the capital of the company for the purposes of determining the standard deductions, as contemplated under Section 2(9) of the Act:
(a) Capital reserve Rs 9,41,488 (b) Rehabilitation reserve Rs 6,00,000 (c) Stores reserve Rs 75,000 (d) Forfeited moneys reserve Rs 8000 (e) Bad and doubtful debts reserve Rs 25,000”
15. The Income Tax Officer rejected the assessee's claim. On appeal the Appellate Assistant Commissioner allowed the claim of the assessee in part. The Revenue and the assessee both went up in appeal before the Tribunal. The Tribunal had allowed the claim of the assessee in full. The Revenue feeling aggrieved referred the following question to the High Court:
“Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that:
(a) capital reserve,
(b) rehabilitation reserve,
(c) stores reserve,
(d) forfeited moneys reserve; and
(e) bad and doubtful debts reserve,
were to be included in computation of capital according to the provisions of the Second Schedule to the Super Profits Tax Act, 1963.”
16. So far as the capital reserve is concerned, in the light of discussion in CIT v. Elgin Mills Ltd. (1986) 3 SCC 655, and also in Civil Appeal No. 1546 of 1974 — CIT v. British India Corpn. Ltd. (1986) 3 SCC 655 the High Court was right in treating this account as reserve. It must be further noted that so far as capital reserve was concerned, the Appellate Commissioner had allowed a sum of Rs 7,19,488 out of a claim of Rs 9,41,488. In appeal, the Tribunal upheld the order of the Appellate Commissioner. The assessee did not seek a reference against this in the High Court. The controversy before the High Court was confined to the claim allowed by the Appellate Commissioner. The High Court held in favour of the assessee in treating it a reserve. The High Court was right.
17. So far as the rehabilitation reserve and stores reserve are concerned, in view of the facts found by the Tribunal and in the light of the reasons indicated in Civil Appeal No. 1546 of 1974, in our opinion, this must be treated as reserve as was held by the Tribunal.
18. The High Court has disallowed the forfeited money reserve to be treated as reserve. We are of the opinion that the High Court was right.
19. So far as bad and doubtful debts are concerned, in the light of the observations made in Civil Appeal No. 1546 of 1974 and in the light of the facts found, this must be treated as reserve.
20. In the aforesaid view of the matter, the appeal fails and is accordingly dismissed. In the facts and circumstances of the case, there is no order as to costs.
21. Special Leave Petition No. 4815-A of 1977 arises out of the decision of the Bombay High Court where the High Court rejected the application under Section 256(2) of the Income Tax Act, 1961, for an order directing the Income Tax Appellate Tribunal, Bombay to state a case in relation to the various items specified in the question. The question was as follows:
“Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that gratuity reserve of Rs 2,00,000, reserve for special survey of Rs 13,04,600, reserve for contingencies of Rs 56,00,000, fleet replacement reserve of Rs 54,35,250, reserve for exempted profits under Section 84 of Rs 1,64,900, reserve for investment depreciation of Rs 7,09,144 and dividend equalisation reserve of Rs 2,00,000 were reserves within the meaning of the Second Schedule to the Act?”
22. The Tribunal by its order dated July 21, 1976, rejected this application as one of fact and the principles not being in dispute.
23. The revenue thereafter applied to the High Court under Section 256(2) of the Act read with Section 18 of the Companies (Profits) Surtax Act, 1964. By its order dated June 20, 1977, the Bombay High Court allowed the application only in relation to the reserve for special survey for Rs 13,04,600 and rejected the application so far as other items are concerned.
24. Being aggrieved, the assessee has come in special leave petition. The facts regarding the same as found by the Tribunal are as follows:
“(i) The gratuity reserve of Rs 2,00,000 was created for the first time during the preceding year. The amount was not claimed as revenue expenditure. Some payments were actually paid during the preceding accounting year. The amount was to be included in the capital base as ‘other reserves’.
(ii) Reserve for special survey: Rs 13,04,600: The balance in this reserve account on the first day of the preceding accounting year was Rs 9,32,500 to which was added Rs 15 lakhs by transfer from the Profits & Loss Account making a total of Rs 24,32,500. During that preceding year expenses of Rs 11,26,900 were incurred and debited to this reserve and the balance of Rs 13,04,600 was carried forward. This amount was to be included in the capital base.
(iii) Reserve for contingencies: Rs 56,00,000: This reserve account was meant to be utilised in case of contingencies and there was no specific liability for spending even a part of this amount on the first day of the accounting year and it was therefore includible in capital base.
(iv) Fleet replacement reserve: Rs 54,35,250: This reserve was like the reserve for contingencies. Here also there was no liability in praesenti towards purchase of any vessel on the first day of the accounting year and this sum also was includible in the capital base.
(v) Reserve for exempted profits under Section 84 of the Income Tax Act: Rs 1,64,900: This was not meant for meeting any liability and had therefore to be included in the capital base.
(vi) Reserve for investment depreciation: Rs 7,09,144: This reserve was created originally in order to cushion the effect of fluctuations in the prices of foreign securities held by the assessee. This amount was ultimately transferred in 1971 to the Profits & Loss Appropriation Account. Here also the reserve was not created by way of making provision for liability already accrued on or before the first day of the accounting year and had therefore to be included in the capital base.
(vii) Dividend equalisation reserve: Rs 2,00,000: This reserve was set apart to enable the assessee to declare reasonable dividend in a year in which the profit was likely to go down. This amount was subsequently transferred to the general reserve in 1971. This amount was also to be included in the capital base.”
25. In view of the facts as recorded by the Tribunal and in the light of the principles settled by various decisions and reiterated by this Court in Civil Appeal No. 1665 of 1974 (1986) 3 SCC 655, it is not necessary to call for any statement of the case and the High Court was right. It may be mentioned that where the liability has actually arisen or is anticipated legitimately by the assessee though the quantum of the liability has not been determined, to meet such present liability cannot be treated as “reserve”. A fund, however, created for payment of a liability which had not already arisen or fallen due but only a provision with regard to the sum that might become liable to be paid is “other reserve” within the meaning of Rule 1 of Second Schedule and should be taken into account in computing the capital of the company for the purpose of the Companies (Profits) Surtax Act, 1964.
26. In that view of the matter, we are of the opinion that the decision of the High Court was right. The principles applicable in these types of cases have been discussed by this Court in several decisions. It is not necessary to reiterate these again.
27. In the premises this application fails and is accordingly dismissed. In the facts of this case, parties will pay and bear their own costs.
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