Commissioner Of Income-Tax, Bombay vs The Century Spinning And Manufacturing

Rewritten Version Notice: This is a rewritten version of the original judgment.

Court: Supreme Court of India

Case Number: Civil Appeals Nos. 157 and 158 of 1952

Decision Date: 8 October, 1953

Coram: Ghulam Hasan, M. Patanjali Sastri, Vivian Bose, Natwarlal H. Bhagwati

In the matter titled Commissioner of Income-Tax, Bombay City versus The Century Spinning and Manufacturing Co. Ltd., the Supreme Court of India delivered its judgment on the 8th of October, 1953. The opinion of the Court was authored by Justice Ghulam Hasan, who was joined by Justices M. Patanjali Sastri, Vivian Bose and Natwarlal H. Bhagwati. The case is reported in the 1953 volume of the All India Reporter at page 501 and is also cited in the 1954 Supplementary Court Report at page 203. Subsequent citations of the decision appear in the law reports of 1961, 1966, and 1981, reflecting its continued relevance in later jurisprudence. The parties before the Court were identified as the Commissioner of Income-Tax for the city of Bombay, who acted as the petitioner, and The Century Spinning and Manufacturing Co. Ltd., who was the respondent. The judgment date, bench composition, and authorial attribution are consistently recorded throughout the official report.

The substantive legal issue in the case concerned the interpretation of Schedule II, Rules 2 and 3 of the Business Profits Tax Act of 1947, particularly as they relate to the determination of a company’s capital. The specific question was whether an amount of accumulated profit that had been carried forward to the next financial year without being formally declared a reserve could nevertheless be treated as a reserve for the purposes of calculating paid-up capital. The dispute also required reference to the Indian Companies Act of 1913, specifically sections 131-A and 132, Schedule I, Table A and Regulation 99, which define the concept of reserves within a corporate accounting framework. The Court was therefore asked to decide whether the undistributed profit in question fell within the statutory definition of reserves under the Business Profits Tax legislation, and consequently whether it should be added to the capital base of the enterprise for the chargeable accounting period beginning on 1 April 1946.

The headnote of the reported judgment summarizes the factual background and the Court’s holdings. For the calendar year ending 31 December 1945, the balance sheet of The Century Spinning and Manufacturing Co. Ltd. recorded a profit of rupees 90,44,677, after accounting for depreciation and tax provisions. Following these deductions, a balance of rupees 5,08,637 remained, which was transferred to the balance sheet of the subsequent year on 1 January 1946 without being earmarked as a reserve. On 28 February 1946, the directors marked this balance for distribution as a dividend, and a formal resolution to that effect was passed on 3 April 1946. The dividend was actually paid a few days after the resolution. The Court held that because the sum of rupees 5,08,637 had never been declared a reserve but had instead been earmarked and distributed as a dividend, it could not be considered a reserve for the purpose of adding to paid-up capital under the relevant rules of Schedule II of the Business Profits Tax Act for the accounting period commencing 1 April 1946. Additionally, the Court held that the profits earned by the company from 1 January to 1 April 1946 could not be treated as reserves either.

The judgment was issued under the civil appellate jurisdiction of the Supreme Court and pertained to Civil Appeals numbered 157 and 158 of 1952. Both appeals originated from the judgment and order dated 29 March 1951, rendered by the High Court of Judicature at Bombay, where Chief Justice Chagla and Justice Tendolkar presided in the original civil jurisdiction. The matters before the High Court arose from Income-Tax Reference No. 27 of 1950, which had been referred by the Income-Tax Appellate Tribunal, Bombay. Counsel for the Commissioner of Income-Tax was G.N. Joshi, while the respondent was represented by R.J. Kolah. The Supreme Court’s judgment was delivered by Justice Ghulam Hasan on the 8th of October 1953. These two connected appeals, one filed by the Commissioner of Income-Tax, Bombay, and the other by The Century Spinning and Manufacturing Co. Ltd., emerged from the Bombay High Court’s decision on the reference made by the Income-Tax Appellate Tribunal. The Court noted that the two questions of law referred were (1) whether the amount of rupees 5,08,637 formed part of the reserves of the assessee company as on 1 April 1946 within the meaning of rule 2(1) of the rules in Schedule II to the Business Profits Tax Act, and (2) whether the profits of the assessee company earned from 1 January to 1 April 1946 should be included in the said reserves as on 1 April 1946. The High Court had answered the first question affirmatively and the second negatively.

The Tribunal framed two questions for reference to the High Court. The first question asked whether the amount of Rs 5,08,637 formed part of the reserves of the assessee company as on 1 April 1946 within the meaning of rule 2(1) of the rules in Schedule II to the Business Profits Tax Act. The second question asked whether the profits of the assessee company earned between 1 January and 1 April 1946 should also be treated as reserves as on 1 April 1946. The High Court answered the first question affirmatively, holding that the sum was indeed a reserve, and answered the second question negatively, holding that the profits of the three-month period were not to be included in the reserves. The assessee’s accounting year followed the calendar year, and the chargeable accounting period for the assessment was the period from 1 April 1946 to 31 December 1946, relating to profits that ended on 31 December 1945. According to the profit and loss account, the company’s profits amounted to Rs 90,44,677 before making provisions for depreciation and taxation. After those provisions were made, the balance of Rs 5,08,637 remained and was transferred to the balance-sheet as a reserve.

Before the Income-Tax Officer, the assessee raised two contentions. The first contention was that the balance of Rs 5,08,637 could be described as a “reserve” within the meaning of rule 2(1) of the Rules in Schedule II to the Business Profits Tax Act and, therefore, should be included in the capital computation as on 1 April 1946. The second contention asserted that the proportionate profit attributable to the three-month period from 1 January 1946 to 1 April 1946 should also be included in the reserves. The Income-Tax Officer rejected both contentions, reasoning that a “reserve” meant profits that had been set aside for a specific or general purpose, and profits not so earmarked could not be treated as reserves for the purpose of capital inclusion. The Appellate Assistant Commissioner affirmed the Officer’s order on appeal, but the Income-Tax Appellate Tribunal set aside that order and referred the two questions to the High Court under section 66(1) of the Act read with section 19 of the Business Profits Tax Act of 1947. As previously noted, the High Court decided the first question in favour of the assessee and the second in favour of the department, giving rise to the present appeals. The Business Profits Tax Act (No XXI of 1947) had come into force on 11 April 1947, replacing the Excess Profits Tax Act which had been repealed on 30 March 1946. The Act was originally intended to tax large profits earned by companies engaged in business during the wartime boom years, and was revived in a modified form after a year’s hiatus. Section 4, the charging provision relevant to this case, authorised the levy of a tax called “business profits tax” on the amount of “taxable profits” for any chargeable accounting period.

Section 4 of the Business Profits Tax Act provided that the tax to be levied on the amount of “taxable profits” for any chargeable accounting period would be sixteen and two-thirds per cent of those taxable profits. The statute defined “taxable profits” as the amount by which the profits earned during a chargeable accounting period exceed the abatement applicable to that period, as stipulated in section 2(17). Section 2(1) defined “abatement” for any chargeable accounting period ending on or before 31 March 1947 as a sum that bears proportionally to a specified base amount. The base amount was described as follows: for a company that is not deemed a firm under section 9, the base amount was the greater of six per cent of the company’s capital on the first day of the period, calculated in accordance with Schedule II, or one lakh rupees. The abatement for the period was then the same proportion as the period bears to a full year. Section 2(2) explained that “accounting period” with respect to any business meant any period that had been fixed as the previous year for that business under the Indian Income-tax Act, 1922. Finally, “chargeable accounting period” was defined in section 2(4) to include (a) any accounting period that fell entirely within the fiscal year beginning 1 April 1946 and ending 31 March, and (b) where an accounting period straddled that fiscal year, only the portion of the period that fell within the fiscal year was to be treated as chargeable. From these provisions it appeared that the concept of abatement was intended to allow a normal profit of six per cent on a company’s capital, and that any profit exceeding this normal amount would be liable to the business profits tax.

Schedule II set out the method for calculating a company’s capital for the purpose of the business profits tax. Rule 2(1) of Schedule II, which was applicable to the present case, provided that where a company was subject to rule 3 of Schedule I, its capital would be the total of its paid-up share capital and its reserves, provided that those reserves had not been allowed in computing the company’s profits for the purposes of the Indian Income-tax Act. The issue before the Tribunal on the first question was whether the assessee could treat a sum of Rs 5,08,637 as a reserve and add it to its paid-up share capital when calculating the abatement. The rule required two essential conditions to be satisfied: first, the amount must not have been allowed as profit under the Income-tax Act, and second, the amount must qualify as a “reserve” within the meaning of the rule. The fact that the amount had not been allowed in profit computation was not contested; consequently, the sole remaining question was whether the sum could be considered a reserve as contemplated by the rule. The balance-sheet of the company indicated that it had generated a profit, leading to the consideration of whether the Rs 5,08,637 balance carried forward could be treated as a reserve for the purpose of computing the abatement.

In the year 1945 the company recorded a profit of ninety lakh forty-four thousand six hundred seventy-seven rupees, which was shown after allowing for depreciation and tax. After making those deductions, an amount of five lakh eight thousand six hundred thirty-seven rupees remained, and this balance was transferred to the balance-sheet on 1 January 1946 as an entry in the profit and loss account. On 28 February 1946 the directors of the company proposed that this remaining sum should be allocated in the following way: they recommended paying a final dividend at a rate of eighteen rupees per share, which together with the interim dividend would make a total of twenty-eight rupees per share for the whole year, and they stated that the dividend would be paid free of income-tax. The directors also indicated that four lakh ninety-two thousand four hundred twenty-six rupees would be retained as a balance to be carried forward to the next year’s account, and that sixteen thousand two hundred eleven rupees and six annas would remain in the account. The shareholders met on 3 April 1946 and passed a resolution approving the directors’ recommendation. The dividend was scheduled to be payable on 15 April 1946 and it was not contested that the dividend was actually distributed on that date. Having set out these facts, the question arose whether the sum of five lakh eight thousand six hundred thirty-seven rupees could be described as a “reserve”. The statute did not define the term “reserve”, so the Court turned to the ordinary meaning of the word as it is used in everyday language. According to the Oxford Dictionary, a reserve is something that is kept for future use or enjoyment, stored for a later occasion, held back for later treatment, set apart for a particular purpose, or retained for certain purposes. Webster’s New International Dictionary similarly defines a reserve as something kept in store for future or special use, something that is retained or held over for a later time, or something that is preserved. To determine the true nature of the disputed amount, the substance of the transaction had to be examined. On the crucial date of 1 April 1946, no person with the authority to decide on the disposition of the sum had indicated how it would be used, and therefore the amount could not be regarded as a reserve at that time. Earlier, on 28 February 1946, the directors had specifically earmarked the sum for distribution as a dividend and had not elected to treat it as a reserve. Likewise, at the shareholders’ meeting on 3 April 1946, no decision was taken to designate the amount as a reserve. Consequently, on 1 April 1946 the sum remained a mass of undistributed profits that were available for distribution and had not been earmarked as a reserve. On 1 January 1946 the amount had merely been carried forward from the profit and loss account to the next year, and no authorized person had on that date declared it to be a reserve.

The Court observed that to characterize a sum as either a general reserve or a specific reserve, there must be an explicit indication showing which type of reserve, if any, it constituted. The mere fact that the amount formed a mass of undistributed profits on 1 January 1946 could not by itself convert it into a reserve. On 1 April 1946, the date that marked the beginning of the chargeable accounting period, the directors only made a recommendation that the sum in question should be paid out as dividend. This recommendation, the Court held, did not demonstrate that the directors had transformed the amount into a reserve; rather, it showed that they intended to earmark the sum for distribution as dividend. Subsequently, the shareholders, by a resolution passed on 3 April 1946, approved the recommendation and the amount was shortly thereafter distributed as dividend. The Court noted that the High Court had apparently misunderstood the factual matrix when it observed: “It was open to the directors to distribute the sum of Rs. 5,08,537 as dividends. They did not choose to do so and have kept back this amount. Therefore, by keeping back this amount they constituted it a reserve. A reserve in the sense in which it is used in rule 2 can only mean profit earned by a company and not distributed as dividend to the shareholders but kept back by the directors for any purpose to which it may be put in future. Therefore, giving to the ‘reserves’ its plain natural meaning, it is clear that the sum of Rs. 5,08,637 was kept in reserve by the company and not distributed as profits and subjected to taxation. Therefore, it satisfied all the requirements of rule 2.” The Court clarified that the directors possessed no authority to distribute the sum as dividend; they could only recommend such a distribution, and the actual distribution could occur only after the shareholders accepted the recommendation. Because the shareholders did accept it, the dividend was duly paid, and it was therefore inaccurate to say that the amount had been retained or kept back as a reserve.

The Court further explained that the nature of the amount remained that of undistributed profits and was unchanged by the shareholders’ acceptance of the dividend recommendation. Consequently, profits that remained unutilised and were not set aside for any specific purpose on the relevant date could not be classified as reserves within the meaning of Schedule II, rule 2(1). The Court referred to sections 131(a) and 132 of the Indian Companies Act. Section 131(a) obliges directors to attach to each balance-sheet a report describing the state of the company's affairs, specifying any amount recommended to be paid as dividend and any amount proposed to be transferred to the Reserve Fund, General Reserve, or Reserve Account. Section 132 deals with the preparation of the balance-sheet in the Form marked F as prescribed in Schedule III, which contains a distinct head for reserves. The Court also cited Regulation 99 of the First Schedule, Table A, which lays down that directors, before recommending any dividend, may set aside from the company's profits such sums as they deem proper as reserves, to be applied at their discretion for contingencies, equalising dividends, or any other proper purpose. In the present case, the directors, while recommending the dividend, took no step to set aside any portion of the sum as a reserve, nor did they consider the matter of reserves at all. The balance-sheet prepared by the assessee reflected the profits in accordance with the Companies Act, and those statutory provisions supported the conclusion that the sum in question could not be regarded as a reserve.

The Court observed that the regulation allowed directors, before recommending any dividend, to set aside from the company’s profits such sum as they deemed proper as a reserve or reserves. These reserves could be applied at the directors’ discretion to meet contingencies, to equalise dividends, or for any other purpose to which the profits of the company might be properly applied. The regulation further required that any amount intended to become a reserve be earmarked before the directors made any recommendation of dividend. In the present case the directors, while recommending the dividend, neither set aside any portion of the profits as a reserve nor gave any thought to that requirement. The balance-sheet prepared by the assessee displayed the profits in accordance with the provisions of the Indian Companies Act, and those same provisions clarified the true nature of a reserve shown in a balance-sheet. The Court concluded that the view adopted by the Bombay High Court was erroneous and therefore had to be set aside. Accordingly, the appeal filed by the Commissioner of Income-Tax was allowed and costs were awarded.

Concerning the second question, the counsel representing the company plainly admitted that the view taken by the High Court on that part of the matter could not be challenged and was correct. The High Court had held that the profits earned during the three-month period from 1 January 1946 to 1 April 1946 did not constitute reserves that would bring the application of rule 2 of Schedule 11. The Court agreed with this finding. Consequently, the assessee’s appeal in that respect was dismissed with costs. The final orders recorded that Appeal No. 157 was allowed, Appeal No. 158 was dismissed, and the agents for the Commissioner of Income-Tax and for the company were respectively G. H. Rajadhyaksha and I. N. Shroff.