The First National City Bank vs The Commissioner Of Income-Tax, Bombay

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

Court: Supreme Court of India

Case Number: 315/1958

Decision Date: 6 January 1961

Coram: J.L. Kapur, M. Hidayatullah, J.C. Shah

The case titled The First National City Bank versus The Commissioner of Income‑Tax, Bombay was decided on 6 January 1961 by the Supreme Court of India. The judgment was authored by Justice J. L. Kapur, with Justices M. Hidayatullah and J. C. Shah forming the bench. The petitioner in the proceeding was The First National City Bank and the respondent was The Commissioner of Income‑Tax, Bombay. The citation for the decision is reported in 1961 AIR 812 and 1961 SCR (3) 371. The matter also appears in later reports such as RF 1966 SC 1393 and RF 1981 SC 2105. The dispute concerned the application of the Business Profits Tax Act, 1947 (Act XXI of 1947) as it related to the term “reserves” in Rule 2(1) of Schedule II of that Act. The appellant bank, a non‑resident institution incorporated under the National Bank Act of the United States of America and having its head office in America, maintained branches worldwide, including several in India. Under United States Treasury Rules and the instructions for the preparation of condition reports issued by the National Banking Association, the bank was required to allocate certain sums under Section 5211 of the Revised Statute of the United States and to retain a specific amount under the heading “undivided profits”. This sum formed an integral part of the bank’s capital structure, serving the purpose of providing a reserve against which losses could be charged, that is, profits set aside after provision for expenses and taxes for continuous use in the business. The bank contended that, for the purpose of computing the amount eligible for abatement under the Indian statute, the “undivided profits” fell within the word “reserves” and therefore should be included in the calculation of capital and reserves. The sole question before the Court was whether the large sum recorded as “undivided profits” could be treated as part of the reserves. The Court held that the amount designated as “undivided profits” is indeed a component of the reserves and must be taken into account when computing capital and reserves pursuant to Rule 2(1) of Schedule II of the Business Profits Tax Act, 1947.

The appeal proceeded in civil appellate jurisdiction as Civil Appeal No. 315/1958, taken on special leave from the judgment and order dated 5 February 1957 of the Bombay High Court in Income‑Tax Reference No. 34 of 1956. Counsel for the appellant and counsel for the respondent were instructed to present the respective positions. The judgment of the Court was delivered by Justice Kapur. The appeal challenged the decision of the High Court of Judicature at Bombay in the said income‑tax reference. The appellant, being a non‑resident bank incorporated under the United States National Bank Act, with its head office situated in the United States and maintaining a network of branches worldwide, including branches in India, was assessed under the Business Profits Tax Act (Act XXI of 1947), hereinafter referred to as “the Act”. The Court examined the meaning of the term “reserves” in Rule 2(1) of Schedule II of the Act and determined the method of computing the appellant’s capital for the purpose of allowing the statutory abatement. By affirming that “undivided profits” constitute a part of the reserves, the Court clarified the computation of capital and reserves under the applicable provision of the Act.

In this appeal the Court considered the accounting periods that fell within the chargeable years, namely the period from 1 April 1946 to 24 December 1946, the period from 25 December 1946 to 24 December 1947, the period from 25 December 1947 to 23 December 1948, and finally the period from 24 December 1948 to 31 March 1949. The only issue that required a decision was the interpretation of the term “reserves” as used in Rule 2(1) of Schedule 2 of the Business Profits Tax Act, 1947, and the method by which the appellant’s capital for each of those chargeable accounting periods should be calculated for the purpose of granting the statutory “abatement” provided under the Act. The appellant maintained that, when the amount of capital was computed for the purpose of the abatement, it was entitled to include the amount described in the United States as “Undivided Profits”. The appellant argued that this category of profit fell squarely within the definition of “reserves” in Rule 2(1) of Schedule 2, which reads: “Where the company is one to which rule 3 of Schedule I applies, its capital shall be the sum of the amounts of its paid‑up share capital and of its reserves in so far as they have not been allowed in computing the profits of the company for the purpose of the Indian Income‑Tax Act, 1922 (XI of 1922), diminished by the cost to it of its investments or other property the income from which is not includable in the profits, so far as that cost exceeds any debt for money borrowed by it.” The appellant therefore asserted that the undivided profits should be aggregated with paid‑up share capital and other reserves in order to arrive at the correct capital figure for the abatement calculation.

To illustrate the point, the appellant referred to the balance sheet dated 31 December 1946, which showed three principal entries: capital of US $77,500,000.00, surplus of US $152,500,000.00, and undivided profit of US $29,534,614.21. The directors’ report dated 14 January 1947 explained that at the close of the year the bank’s capital remained at US $77,500,000, while the surplus had risen to US $152,500,000 as a result of a transfer of Rs. 10,000,000 from the undivided profits. After that transfer the undivided profits stood at US $29,534,614, an increase of US $240,376 compared with the previous year. The report also noted that the Trust Company held a capital of US $10,000,000, a surplus of US $10,000,000, and undivided profits of US $8,097,020. Together, the two institutions reported total capital funds—being the sum of capital, surplus and undivided profits—of US $287,631,634, which corresponded to US $46.39 per share, an improvement over the US $44.60 per share recorded at the end of 1945. The appellant further cited the balance sheet for the year 1948, which indicated that capital funds had risen from US $169,768,000 in 1939 to US $320,795,000 in 1948. Both the “Surplus” and the “Undivided Profits” had shown a steady increase; surplus had grown from US $62,500,000 to US $182,500,000, and undivided profits had risen from US $19,768,000 to US $50,795,000. The central question presented to the Court was whether this substantial amount identified as “Undivided Profits” should be treated as part of the reserves under the statutory definition, or whether it was merely the unallocated balance that remained at the end of the profit and loss account and therefore should be excluded from the capital computation.

In the contested accounting year the balance of the Profit and Loss Account contained an amount of $ 29,534,614.21, and similar amounts existed for the other chargeable accounting periods that formed the subject of the appeal. The Income‑tax Officer and the Appellate Assistant Commissioner each excluded those sums from the calculation of the bank’s capital under Rule 2(1) of Schedule II, reasoning that the sums were not part of the bank’s reserves. The appellant therefore brought the matter before the Income‑tax Appellate Tribunal. The Tribunal dismissed the appeal on the basis that “Undivided Profits” was merely another term for the “balance of the profit and loss account” and that no legal distinction could be drawn simply because United States practice labelled the amount as “Undivided Profits” rather than as a balance of profit and loss. At the appellant’s request, the legal question was referred to the High Court: whether, on the facts and in the circumstances of the case, the Undivided Profits of $ 29,534,614.21 shown in the condensed statements of condition as of 31 December 1946 could be treated as reserves and added to capital as required by Rule 2(1) of Schedule II to the Business Profits Tax Act for the chargeable accounting period 25 December 1946 to 24 December 1947.

The Tribunal, in its order, explained that United States Treasury rules divided the capital account into four heads – Capital, Reserve, Surplus and Undivided Profits. It described reserves as amounts set aside for liabilities, including dividend reserves, and observed that the “general reserves” shown in Indian balance sheets correspond to the surplus, while “Undivided Profits” correspond to the balance of the profit and loss account. The Tribunal’s statement of case to the High Court asserted that whether Undivided Profits meant the same as the balance of profit and loss was a factual issue and that the nomenclature was immaterial. The High Court, after examining the directors’ report filed with shareholders, held that the Undivided Profit of $ 29,534,614.21 did not constitute “reserves” because no direction had been given to transfer it to any reserve, it had never been earmarked for a specific purpose, and the only voluntary act of the directors was to transfer $ 10 million to surplus. In its judgment the High Court observed: “It is true that these large amounts (of Undivided Profits) remain with the Bank, that the Bank uses them, that business is carried on with the help of those funds and that they are as much capital of the Bank as capital in the strict sense of the term.”

The High Court had concluded that the amounts in question did not satisfy the test articulated by the Supreme Court in the case of Century Spinning and Manufacturing Co. Ltd. v. C.I.T., Bombay, because the sum had not been transferred to any reserve and, in the absence of any volitional act by the Directors, the amount could not be characterised as a reserve. That conclusion was placed before this Court for review. The Directors’ report dated 14 January 1947 was examined and it showed that the surplus of the Bank had been increased by an allocation of ten million dollars made by the Directors out of the Undivided Profits. In the same year the balance of the Undivided Profits rose to $29,534,614.21, an increase of $240,376 over the previous year, 1946. Consequently the total capital funds of the company – comprising Capital, Surplus and Undivided Profits, together with similar items from the Trust Company – had risen markedly. This increase was reflected in the per‑share value, which moved from 44.60 per share at the close of 1945 to 46.39 per share at the close of 1946. The record therefore demonstrated that the Directors had deliberately acted to enlarge the Surplus and to retain a specific sum within the Undivided Profits.

The opposing side argued that a sum could be treated as “Reserves” only if the Directors formally recommended such an allocation and the shareholders subsequently adopted it. The Court observed, however, that this argument overlooked material evidence submitted by the appellant. Under the Treasury Rules of the United States of America, which contain the “Instructions for Preparation of Reports of Condition by National Banking Associations,” certain amounts must be specifically allocated in accordance with section 5211 of the revised United States Statutes (Title 12, U.S.C. 161). Items 25 to 28 of those instructions deal respectively with the Capital Account, Surplus, Undivided Profits and Reserves (including a retirement account for preferred stock). The Reserves listed under item 28 comprise a reserve for dividends payable in common stock, reserves for other undeclared dividends, a retirement account for preferred stock, and reserves for contingencies, among others. Item 29, titled “Total capital accounts,” aggregates the amounts in items 25 through 28. In support of its position, the appellant also produced a letter from the Deputy Controller of Currency in Washington, which affirmed that, in United States banking practice, the Undivided Profits shown on a bank’s balance sheet constitute a component of its capital funds, and that all supervisory banking agencies in the United States treat Undivided Profits as part of the capital base when assessing a commercial bank’s adequacy of capital.

In the United States, supervisory authorities treat the item called “Undivided Profits” as an essential component of a bank’s capital structure, because without including it an accurate calculation of capital would be impossible. When a bank suffers losses, the common practice is to charge those losses against the Undivided Profits account; this treatment would be unsuitable if the account were considered “Undistributed Profits.” American commercial banks do not keep a separate account that can be described as “Undistributed Profits” in the way similar accounts are maintained by corporations in India. The term “Undivided Profits” follows the banking accounting terminology used in the United States and denotes profits that are retained after provisions for expenses, taxes, dividends and reserves have been made, and which are set aside for ongoing use in the bank’s business. This concept is closely related to, and in many respects identical with, the earned surplus account of an industrial corporation. The balance sheets of three United States banks cited by the appellant demonstrate that the capital fund consists of three categories of funds: capital, surplus and Undivided Profits. The record shows that these three categories together constitute what is called the “Capital Fund.” The creation and maintenance of the Undivided Profits item is mandated by Treasury Rules issued under the Statute, so the amount shown as Undivided Profits on a bank’s balance sheet cannot be said to be unallocated or the result of an arbitrary decision; rather, it arises from a statutory requirement, a resolution of the directors and acceptance by the shareholders. The Deputy Controller of Currency’s letter specifies that Undivided Profits must be employed for expenses, taxes, dividends and reserves, and used continuously in the bank’s operations; they form part of the capital funds and are integral to the capital structure, without which a precise computation of capital would be unattainable. The letter further explains that the purpose of this fund is to allow losses to be charged against Undivided Profits, which represent profits set aside after meeting all expense, tax and dividend obligations for the bank’s continued business. The accounting system for banking companies in India differs from that in the United States, and a failure to recognize this difference led both the Appellate Tribunal and the High Court to reach an incorrect conclusion. In India, any unallocated profit or loss at the end of a fiscal year is carried forward to the next year’s account and merged with that year’s figures. In contrast, United States banking accounting treats each year as a self‑contained period; nothing is carried forward. If, after allocating profits

When, after allocating amounts to the various heads previously mentioned, a balance still remains, that balance is credited to Undivided Profits, which are then incorporated into the capital fund of the banking company. In any year where the allocation results in a loss, the bank draws first on the accumulated Undivided Profits of preceding years; if those accumulated profits are exhausted, the bank subsequently draws on its surplus. By definition, Undivided Profits represent the residual amounts left on hand at the close of each accounting year, and these residual sums are accumulated over successive accounting periods. Under the prevailing accounting practice and the directions issued by the Treasury, such accumulated residual amounts are treated as part of the bank’s capital fund. This characterization of Undivided Profits was examined by the Supreme Court of the United States in the case of Fidelity Title and Trust Co. v. United States. In that American case, Fidelity Title and Trust Company sought recovery of a tax imposed on its entire capital and its Undivided Profits pursuant to section 2 of the Spanish War Revenue Act. The company argued that the terms “capital,” “surplus,” and “Undivided Profits” possessed precise, distinct meanings in banking, asserting that Undivided Profits were not surplus and therefore could not be taxed as surplus. The government, by contrast, maintained that Undivided Profits formed part of capital or surplus and were therefore taxable. The Court concluded that Undivided Profits were taxable as part of the capital employed. Justice Brandeis, delivering the opinion, explained that the statute required the inclusion of capital and surplus in estimating tax, and that the tax for any fiscal year must be computed on the basis of the capital and surplus of the preceding fiscal year. He further observed that the tax liability depends on the use or employment of capital in banking rather than mere ownership, and that a portion of capital designated as Undivided Profits carries no special legal significance.

The meaning of the term “Reserves” as used in the Business Profits Tax Act was subsequently considered by this Court in Commissioner of Income‑Tax v. Century Spinning & Manufacturing Co. Ltd. The Court held that the true nature and character of an amount contested as a reserve must be determined by examining the substance of the transaction. In that case, the disputed amount consisted of profits remaining after deductions for depreciation and tax; these profits were carried to the balance sheet and later recommended by the directors for distribution primarily as dividends, with any balance to be carried forward to the following year’s account. Consequently, on the pivotal date of 1 April 1946, which marked the commencement of the chargeable accounting period, the amount in dispute had not been formally declared a reserve. The Court’s analysis emphasized that a sum may only be classified as a reserve if it is clearly identified as such, rather than merely being an undistributed profit awaiting possible future distribution. This reasoning aligns with the principle that reserves represent undistributed earnings retained for specific future purposes, and not simply any surplus carried forward.

In this case the Court examined the manner in which the directors had treated a particular sum of profit. The directors had set aside the sum for possible distribution as a dividend, yet it remained a mass of undistributed profits that was still available for distribution. The Court referred to the observations of Ghulam Hassan J. recorded at page 209, where the judge explained that a reserve may be either a general reserve or a specific reserve, but that there must be a clear indication showing which kind of reserve it is. The judge further stated that the mere fact that the sum constituted a mass of undistributed profits on 1 January 1946 could not by itself convert the sum into a reserve. According to the judge, a reserve within the meaning of rule 2 is limited to profit earned by a company that has not been distributed as dividend to shareholders and that has been retained by the directors for any purpose they may decide to apply it to in the future. Applying this test to the disputed amount, the Court concluded that the amount could not be said to fall outside the meaning of “Reserve” as defined in the Rules. The Court pointed to the instruction under section 5211 of the Revised Statute of the United States and to the letter of the Deputy Controller previously cited, which required the appellant bank to retain a certain sum of money under the heading “Undivided Profits.” The Court noted that this sum formed an integral part of the bank’s capital structure, as recognized in the decision reported in [1954] S.C.R. 203. Under these circumstances the Court held that it would be erroneous not to treat the amount classified as “Undivided Profits” as part of the capital fund. Consequently, the Court opined that the amount designated as Undivided Profits constituted a part of the reserves and therefore had to be taken into account when computing the capital and reserves in accordance with rule 2(1) of Schedule 11 of the Act. The Court observed that the question referred by the Tribunal should have been decided affirmatively in favour of the appellant and that the amount should have been added to the capital as permitted by rule 2(1) for the chargeable accounting periods. Accordingly, the Court allowed the appeal, ordered that the appellant would be awarded costs in both this Court and the High Court, and entered the judgment in the appellant’s favour.