G. Sivarajan, J. 1. The following two questions are referred at the instance of the Revenue for decision of this court :
"(a) Whether, on the facts and in the circumstances of the case, the Appellate Tribunal is right in law in holding that the loan redemption reserve amounting to Rs. 1 crore is a reserve and not a provision and is to be included in the computation of capital for the purpose of surtax ?
(b) Whether, on the facts and in the circumstances of the case and in view of the Supreme Court decision in the case of Vazir Sultan Tobacco Co. Ltd. v. CIT [1981] 132 ITR 559, the Appellate Tribunal is right in holding so?"
2. The matter arises under the Companies (Profits) Surtax Act, 1964, hereinafter referred to as "the Act". The assessment year concerned is 1985-86, the relevant previous year ended on December 31, 1985,
3. The brief facts necessary for decision of the case as set out in the statement of case forwarded by the Income-tax Appellate Tribunal are as follows :
The assessee is a company in which the public are substantially interested, where the State Government holds 83 per cent. of the paid-up capital. For the assessment year 1985-86, the assessee filed a return of chargeable profits under the Act declaring chargeable profits at "nil". The Deputy Commissioner of Income-tax (Assessment), Special Range, Trivan-drum, who is the assessing authority, completed the assessment computing the chargeable profits at Rs. 71,49,980. The difference between the admitted figure and the assessed figure was Rs. 1 crore. This amount represented "loan redemption reserve" included by the assessee in the "capital employed". The assessing authority disallowed the same in the computation of capital: The assessee objected to the disallowance and carried the matter in appeal before the Commissioner of Income-tax (Appeals). The disallowance of the sum of Rs. 1 crore was affirmed by the said authority following the guidelines laid down by the Supreme Court in Metal Box Co. of India Ltd. v. Their Workmen [1969] 73 ITR 53 and Vazir Sultan Tobacco Co. Ltd. v. CIT [1981] 132 ITR 559. Aggrieved by the said order, the assessee filed appeal before the Income-tax Appellate Tribunal. It was contended by the assessee before the Tribunal that the loan redemption reserve was not created as a result of any contract between the lender and borrower and that the company, for the sake of its own convenience, appropriated certain amounts annually from out of its profits towards redemption of its loans taken from the Government and, therefore, it partakes the nature of reserve only. The Tribunal accepted the said contentions of the assessee and directed the assessing authority to include the sum of Rs, 1 crore in the capital of the company for the purpose of surtax. For arriving at the said conclusion, the Tribunal applied the principles laid down by the Supreme Court in Vazir Sultan Tobacco Co. Ltd.'s case [1981] 132 ITR 559 mentioned supra. Aggrieved by the said order of the Appellate Tribunal, the Revenue applied for reference of the questions set out supra and the Tribunal referred the same for decision of this court. The main contention urged by Sri. P. K. R. Menon, learned senior Central Government standing counsel for taxes, is that the sum of Rs. 1 crore set apart in the profit and loss account of the company towards "loan redemption reserve" is in fact only a "provision" and that at any rate, it cannot be considered as a "reserve" for inclusion in the computation of capital for determining the "standard deduction" for the purposes of the Act. Counsel submitted that the amount which is set apart under "loan redemption reserve" is towards a known or existing liability and, therefore, going by the decisions of the Supreme Court and some of the High Courts, the said amount represents only a provision to meet an existing or known liability. According to him, if the amount is set apart after the liability had already accrued, the amount so set apart is only a "provision" to meet the accrued liability and the same cannot be treated as a "reserve". He further submitted that if the amount is set apart towards a future liability, it cannot be treated as a "provision" and the same will amount to a reserve. According to him, the case on hand falls within the first category. In order to substantiate the said contention, he took us to paragraph 5 of the Tribunal's order, particularly the observation that "the agreed schedule of repayment of the loans and the interest thereon is found at page 41 of the paper book and it is admitted on both sides that the assesses had not kept to the schedule so far as repayment is concerned" (underlining supplied). Counsel further referred to annexuro-D which is The annual report of the company relating to the financial year 1986-87 particularly "item No. 3, loan from State Government" and submitted that the statement of the company that it had obtained Rs. 491 lakhs-from the Government of Kerala as loan between 1968 to 1973 and 1983 for the expansion of the titanium dioxide plant and that the company could repay only Rs. 115.50 lakhs till March, 1987, leaving a balance of Rs. 377.50 lakhs, clearly shows that there was an existing liability and,that it is only towards repayment of that liability that the alleged loan redemption reserve is made. In support of his submissions, counsel relied on the decisions of the Supreme Court in Vazir Sultan Tobacco Co. Ltd. v. CIT[1981] 132 ITR 559 ; CIT v. Elgin Mills Ltd, [1986] 161 ITR 733 and State Bank of Patiala v. CIT [1996] 219 ITR 706.
4. On the other hand, Sri. P. R. Raman, learned counsel appearing for the assessee, submitted that the amount of Rs. 1 crore set apart under the ''loan redemption reserve" is made without any reference to any particular creditor or for repayment of any particular item of debt. It is stated that the loan redemption reserve was created in the financial year 1970, that in the financial years subsequent thereto up to the period ended December 31, 1980, excepting for the year 1979 the assessee has set apart Rs. 10 lakhs each every year under the above head and during the subsequent years up to the year ended March 31, 1987, the said amount of Rs. 100 lakhs remained as a reserve and that the same was transferred to the general reserve in the year 1988. Counsel also submitted that the amounts credited to the loan redemption reserve were not invested outside the company. He further submitted that the said sum remained internally invested and that no part of the amount was appropriated to any expenses such as repayment of the loan, etc. He submitted that there was no agreement with the creditors including the Government of Kerala for creation of any loan redemption reserve and that the said reserve was made only voluntarily and as a reserve against an eventuality. The loan redemption reserve thus created is not a charge against the profit of any year and, on the other hand, it was set apart from out of the profits. He further submitted that these are the findings of the Tribunal and that on the basis of the said findings, the principles laid down by the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559 squarely applied. Counsel submitted that the decision of the Supreme Court in CIT v. Saran Engineering Co. Ltd. [1986] 161 ITR 741 squarely applied to the facts of the case. He also relied on the decision of the Supreme Court in CIT v. Jyoti Ltd. [1996] 219 ITR 388, the decisions of the Madras High Court in CIT v. Lucas Indian Services Ltd, [1905] 212 ITR 382 and CIT v. Hemalatha Textiles Lid. [1990] 183 ITR 461 and also the decision of the Andhra Pradesh High Court in CIT v. Vazir Sultan Tobacco Co. Ltd. [1988] 173 ITR 567. Counsel accordingly submitted that the Tribunal was perfectly justified in holding that the amount of Rs. 1 crore shown as "loan redemption reserve" is not a provision and that it is to be included in the computation of capital for the purposes of surtax.
5. We have considered the rival submissions. It is clear from annexure-D, annual report of the company for the financial year 1986-87, item No. 3 in the directors' report that the company had obtained Rs. 491 lakhs from the Government of Kerala as loan between 1968 and 1973 and 1983 for the expansion of the titanium dioxide plant. It is also seen that up to March, 1987, the company could repay only a sum of Rs. 115.50 lakhs and that the balance of the loan outstanding as on March 31, 1987, was Rs. 377.50 lakhs which included a sum of Rs. 245 lakhs being overdue instalments of principal from 1985 onwards. It is further seen from the report mentioned above that out of the sum of Rs. 245 lakhs outstanding two instalments totalling Rs. 102 lakhs were repaid to the Government during June, 1987. The arrears due to the Government towards principal of loan account as on the date of presentation of the report was Rs. 143 lakhs. Thus, from the report of the directors it is clear that the company had taken loans from the Government right from 1968 till 1983 and that there were occasional repayments in instalments though not regular. It is also evident that the total amount of loan outstanding was very substantial. The case of the assessing authority as could be seen from the assessment order for disallowing the sum of Rs. 1 crore standing in the credit side under the head "Loan redemption reserve" is that even if it is conceded that it is an appropriation from profits by way of a fund even then it partakes of the nature of a "sinking fund" only which can be only for clearing of an ascertained liability. It is the further case of the assessing authority that the fact that a sum has been set apart for redeeming liabilities, makes it obvious that the intention is for clearing a liability and not acquiring an asset. It is further observed by the assessing authority that the amounts set apart under the loan redemption reserve are seen utilised not for the acquisition of any capital asset but for clearing liabilities which include income-tax liabilities. According to the assessing authority, these circumstances will clearly make the said amount a "provision" by applying the principles laid down by the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559. Coming to the first appellate authority, he refers to the submission of the assessee that the loan redemption reserve was created by appropriation of profits and not as a charge against profits and that the reserve was retained in the business as a part of the business assets. But, according to the first appellate authority, the fact that a sum has been set apart for redeeming liabilities makes it obvious that the intention was for clearing a liability and not for acquiring an asset. The first appellate authority also stated that a verification of the actual mode in which the loan redemption reserve has been actually utilised, bears ample testimony to this. The first appellate authority also relied on the decision of the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559 mentioned above and also the observations of the Supreme Court in Metal Box Co. of India Ltd. v. Their Workmen [1969] 73 ITR 53 and held that the assessing authority has rightly excluded a sum of Rs. 1 crore from the computation of capital. The Tribunal in its appellate order referred to the facts and the submissions made by the authorised representative of the appellant as well as the Departmental representative and also the decisions relied on by them and considered the matter in para. 5 of its appellate order. The Tribunal noted that the loan redemption reserve was created in the year 1970 and every year Rs. 10 lakhs was set apart to the loan redemption reserve account up to and including the year 1980 excepting for the year 1979 and also noted that the total amount thus set apart came to Rs. 100 lakhs which remained under the head, "Loan redemption account" up to March 31, 1987, and thereafter, no amount was set apart under the said head. The details noted by the Tribunal in para. 5 also show that the Government loan outstanding as on December 31, 1970, was Rs. 121 lakhs and that the said loan amounts increased in the subsequent three years and thereafter it stood reduced to some extent and as on March 31, 1985, the amount outstanding was Rs. 461.25 lakhs. The Tribunal also referred to the Government orders whereby loans were sanctioned to the assessee and observed that it is seen that there was no stipulation by the Government for the creation of "loan redemption reserve". The Tribunal also found that the agreed schedule of repayment of the loans and the interest thereon is given at page 41 of the paper book and it is admitted on both sides that the assessee had not kept to the schedule so far as repayment is concerned. The Tribunal also observed that the board of directors of the assessee, on their own volition, had created a loan redemption reserve by making appropriation of profits of Rs. 10 lakhs each year beginning from 1970 to 1978 when the reserve stood at Rs. 90 lakhs. It is also observed that in 1979 there was no appropriation whereas there was appropriation of Rs. 10 lakhs for the year 1980 and the total reserve amounting to Rs. 100 lakhs remained undisturbed till the year 1987 and in the year 1988 the same was transferred to the general reserve. The Tribunal also found as a fact from a perusal of the balance-sheet that the amounts credited to the "loan redemption reserve" were not invested outside the company but remained internally invested. The Tribunal then referred to the decision of the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559 and extracted the following passage from the said decision (headnote) :
"The true nature and character of the appropriation must be determined with reference to the substance of the matter : this means that one must have regard to the intention with which and the purpose for which the appropriation has been made, such intention and purpose being gathered from the surrounding circumstances. The following aspects provide some guidelines: (a) a mass of undistributed profits cannot automatically become a reserve and 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."
6. Thereafter, it was observed that from the manner in which the reserve is created out of profits without any obligation on its part so to do, the fact that the funds are internally invested in the business of the assessee in contradistinction to investment outside the business and the further fact that no appropriation was made to the reserve account in the year 1979 and the ultimate transfer of the loan redemption reserve to the general reserve in the year 1988, it can very well be concluded that the guidelines laid down by the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559, are very well satisfied. The Tribunal also noted the fact that the amount appropriated was not against the profits but from out of the profits and that the loan redemption reserve did not bring any fresh liability because the liability was already in existence. It is further observed that the asses-see's case is also supported by the decision of the Calcutta High Court in CIT v. Peico Electronics and Electricals [1987] 166 ITR 299, and that it is well settled that when there are two rival decisions one in favour of the assessee and the other against the assessee, the one that is favourable to the assessee can be adopted. The Tribunal accordingly directed the assessing authority to include the sum of Rs. 1 crore in the capital of the company for the purposes of surtax.
7. Before proceeding with the matter further, it will be profitable to refer to the relevant provisions of the Companies (Profits) Surtax Act, 1964, which was enacted by Parliament with a view to impose a special tax on the profits of certain companies. The charging section, Section 4 reads as follows :
"4. Charge of tax.--Subject to the provisions contained in this Act, there shall be charged on every company for every assessment year commencing on and from the first day of April, 1964, a tax (in this Act referred to as the surtax) in respect of so much of its chargeable profits of the previous year or previous years, as the case may be, as exceed the statutory deduction, at the rate or rates specified in the Third Schedule."
8. The expression "chargeable profits" is defined in Clause (5) of Section 2 as "the total income of an assessee computed under the Income-tax Act, 1961, for any previous year or years, as the case may be, and adjusted in accordance with the provisions of the First Schedule." The expression "statutory deduction" is defined in Clause (8) of Section 2, the relevant portion reads as follows :
" 'Statutory deduction' means an amount equal to ..... per cent, of the capital of the company as computed in accordance with the provisions of the Second Schedule, or an amount of ..... whichever is greater."
9. The Second Schedule contains the rules for computing the capital of a company for the purposes of the Act. Rule (1) including the Explanation thereto reads as follows :
"1. Subject to the other provisions contained in this Schedule, the capital of a company shall be the aggregate of the amounts, as on the first day of the previous year relevant to the assessment year, of-
(i) its paid-up share capital ;
(ii) its reserves, if any, created under the proviso (b) to Clause (vib) of Sub-section (2) of Section 10 of the Indian Income-tax Act, 1922 (31 of 1922), or under Sub-section (3) of Section 34 of the Income-tax Act, 1961 (43 of 1961) ;
(iii) its other reserves as reduced by the amounts credited to such reserves as have been allowed as a deduction in computing the income of the company for the purposes of the Indian Income-tax Act, 1922 (11 of 1922), or the Income-tax Act, 1961 (43 of 1961) ;
(iv) the debentures, if any, issued by it to the public :
Provided that according to the terms and conditions of issue of such debentures, they are not redeemable before the expiry of a period of seven years from the date of issue thereof ; and
(v) any moneys borrowed by it from the Government or the Industrial Finance Corporation of India or the Industrial Credit and Investment Corporation of India or any other financial institution which the Central Government may notify in this behalf in the Official Gazette or any banking institution (not being a financial institution notified as aforesaid) or any person in a country outside India :
Provided that such moneys are borrowed for the creation of a capi-tal asset in India and the agreement under which such moneys are borrowed provides for the repayment thereof during a period of not less than seven years.
Explanation--For the removal of doubts it is hereby declared that any amount standing to the credit of any account in the books of a company as on the first day of the previous year relevant to the assessment year which is of the nature of item (5) or item (6) or item (7) under the heading 'Reserves and surplus' or of any item under the heading 'Current liabilities and provisions' in the column relating to 'Liabilities' in the 'Form of balance-sheet' given in Part I of Schedule VI to the Companies Act, 1956 (1 of 1956), shall not be regarded as a reserve for the purposes of computation of the capital of a company under the provisions of this Schedule."
10. A reading of rule (1) shows that subject to the other provisions contained in the said Schedule, the capital of a company shall be the aggregate of the several amounts mentioned in the said rule as on the first day of the previous year relevant to the assessment year. The items which have to be aggregated include the reserves mentioned in Clauses (ii) and (iii) and the borrowed amounts mentioned in Clause (v). The Explanation appended to the rule is clarii'icatory in nature and refers to the form of balance-sheet given in Part I of Schedule VI to the Companies Act, 1956, and says that any amount standing to the credit of any account in the books of a company (as on the first day of the previous year relevant to the assessment year) which is of the nature of item (5) or item (6) or item (7) under the heading "Reserves and surplus" or of any item under the heading "Current liabilities and provisions" in the column relating to liabilities, shall not be regarded as reserves for the purposes of the Act.
11. The distinction between "reserves" and "provision" has been dealt with by a Constitution Bench of the Supreme Court in CIT v. Century Spinning and Manufacturing Co. Ltd. [1955] 24 ITR 499. That was a case where for the year ending December 31, 1945, the assessee-company which had a certain sum according to the profit and loss account, after making provision for depreciation and taxation, carried the balance amount of Rs. 5,08,637 to the balance sheet. The assessing authority did not allow the said sum in computing the profits of the assessee for the purposes of income-tax. In February 1946, the directors of the assessee recommended that out of the said amount, a sum of Rs. 4,92,426 should be distributed as dividend and the balance of Rs. 16,211 was to be carried forward to the next year's account. This recommendation was accepted by the shareholders in their meeting held on April 3, 1946, and the amount was shortly afterwards distributed as dividend. The question which came up for consideration before the High Court was as to whether the amount of Rs. 5,08,637 is a part of the reserves of the assessee-company as on April 1, 1946, within the meaning of rule 2(1) of the rules in Schedule II of the Business Profits Tax Act and as to whether the profits of the assessee-com-
pany from January 1, 1946, should be included in the said reserves as on April 1, 1946. The High Court held that the said sum must be treated as a reserve for the purpose of rule 2, but, the profit, made by the assessee during the period from January 1, 1946 to April 1, 1946, could not be included in the reserves. On appeal, the Supreme Court held that the sum of Rs. 5,08,637 and the profit earned by the assessee during the period January 1, 1946 to April 1, 1946, did not constitute reserves within the meaning of rule 2(1) of Schedule II.
12. The Business Profits Tax Act (No. XXI of 1947), came into force on April 11, 1947, which has taken the place of the Excess Profits Tax Act which was repealed on March 30, 1946. This Act was also designed to assess large profits made by companies carrying on business during the boom years of the war. Though the provisions of Section 4 of the Business Profits Tax Act are not in parj materia, the expression "abatement" occurring in the definition of "taxable profits" mentioned in Section 4 is defined in Section 2(1) of the said Act to mean, in respect of any chargeable accounting period ending on or before March 31, 1947, a sum which bears to a sum equal to-
"(a) in the case of a company, not being a company deemed for the purposes of Section 9 to be a firm, six per cent. of the capital of the company on the first day of the said period computed in accordance with Schedule II, or one lakh of rupees, whichever is greater .... the same proportion as the said period bears to the period of one year."
13. It appears that the definition of "abatement" contemplates that the normal profit of a company is six per cent. on its "capital" and where the profit exceeds that amount, it becomes liable to pay business profits tax. Schedule II of the said Act lays down the rule for computing the "capital" of a company for purposes of business profits tax and rule 2(1) of the Schedule lays down that 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 purposes of the Indian Income-tax Act. From the above provisions, it is clear that though the provisions of Section 4 of the Companies (Profits) Surtax Act, 1964, and the provisions of Section 4 of the Business Profits Tax Act, 1947, are not similarly worded, the relevant provisions regarding the computation of capital in both the enactments are similar and, therefore, the principles laid down by the Constitution Bench in this case will equally apply for deciding the questions involved in the case on hand. With reference to the provisions of the Business Profits Tax Act mentioned above, the Supreme Court observed that in order to hold that the assessee is entitled to treat the sum of Rs. 5,08,637 as a reserve and to add it to its paid-up share capital for the purposes of computing the abatement, the assessee should satisfy that the amount should not have been allowed in computing the profits of the company for the purposes of the Income-tax Act and that it should be a reserve as contemplated by the rule. The Supreme Court also observed that the fact that it has not been so allowed is not denied and therefore the only question is whether it can be treated as a reserve within the meaning of the rule. The Supreme Court then considered the question as to whether on the basis of the facts found in that case the amount in question can be called a "reserve". It is in that context the Supreme Court observed that the term "reserve" is not defined in the Act and therefore the court must resort to the ordinary natural meaning as understood in common parlance. Thereafter, the Supreme Court referred to the dictionary meaning of the word "reserve" as found in various dictionaries and observed as follows (page 504) :
"What is the true nature and character of the disputed sum, must be determined with reference to the substance of the matter and when this is borne in mind, it follows that on April 1, 1946, which is the crucial date, the sum of Rs. 5,08,637 could not be called a 'reserve' for nobody possessed of the requisite authority had indicated on that date the manner of its disposal or destination. On the other hand, on February 28, 1946, the directors clearly earmarked it for distribution as dividend and did not choose to make it a reserve. Nor did the company in its meeting on April 5, 1946, decide that it was a reserve. It remained on April 1, as a mass of undistributed profits which were available for distribution and not earmarked as 'reserve'. On January 1, 1946, the amount was simply brought from the profit and loss account to the next year and nobody with any authority on that date made or declared a reserve. The reserve may be a general reserve or a specific reserve, but there must be a clear indication to show whether it was a reserve either of the one or the other kind. The fact that it constituted a mass of undistributed profits on January 1, 1946, cannot automatically make it a reserve. On April 1, 1946, which is the commencement of the chargeable accounting period, there was merely a recommendation by the directors that the amount in question should be distributed as dividend. Far from showing that the directors had made the amount in question a reserve, it shows that they had decided to earmark it for distribution as dividend. By the resolution of the shareholders on April 3, 1946, the amount was shortly afterwards distributed as dividend. The High Court appear to have been under a misapprehension as to the real position, for they 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 '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 directors had no power to distribute the sum as dividend. They could only recommend, as indeed they did, and it was up to the shareholders of the company to accept that recommendation in which case alone the distribution could take place. The recommendation was accepted and the dividend was actually distributed. It is, therefore, not correct to say that the amount was kept back. The nature of the amount which was nothing more than the undistributed profits of the company, remained unaltered. Thus the profits lying unutilised and not specially set apart for any purpose on the crucial date did not constitute reserves within the meaning of Schedule II, rule 2(1)."
14. The Constitution Bench then referred to the provisions of Sections 131(a) and 132 of the Indian Companies Act, the form of balance-sheet and also regulation 99 of the First Schedule and with reference to the said provisions the Bench further observed as follows (page 505) :
"Section 131(a) enjoins upon the directors to attach to every balance sheet a report with respect to the state of the company's affairs and the amount if any which they recommend to be paid by way of dividend and the amount, if any, which they propose to carry to the reserve fund, general reserve or reserve account. The latter Section refers to the contents of the balance-sheet which is to be drawn up in the Form marked F in Schedule III. This Form contains a separate head of reserves. Regulation 99 of the First Schedule, Table A, lays down that the directors may, before recommending any dividend set aside out of the profits of the company such sums as they think proper as a reserve or reserves which shall, at the discretion of the directors, be applicable for meeting contingencies, or for equalising dividends, or for any other purpose to which the profits of the company may be properly applied, .....'. The Regulation suggests that any sum out of the profits of the company which is to be made as a reserve or reserves must be set aside before the directors recommend any dividend. In this case the directors while recommending dividend took no action to set aside any portion of this sum as a reserve or reserves. Indeed they never applied their mind to this aspect of the matter. The balance-sheet drawn up by the assessee as showing the profits was prepared in accordance with the provisions of the Indian Companies Act. These provisions also support the conclusion as to what is the true nature of a reserve shown in a balance-sheet."
15. Again the question as to whether the amounts designated as "undivided profits" should be treated as "reserve" and added to the capital for the purposes of abatement under the Business Profits Tax Act, came up for consideration before a three judges' Bench of the Supreme Court in first National City Bonk v. CIT [1961] 42 ITR 17. That was a case where the asses-see which was a non-resident bank incorporated under the National Bank Act of the United States of America, following the system of accounting adopted by American banks and which conformed to the instructions contained in the Treasury Rules of the U.S.A., set aside and transferred the net profits of each year, after provision for expenses, taxes, dividends and reserves, to an account headed "undivided profits". The statute under which an allocation had to be made under that account treated "undivided profits" as part of the capital funds of the bank. When losses occurred it was the usual practice in many banks to charge them against the "undivided profits" account. The profits transferred to the "undivided profits" account were available for continuous future use in the business of the bank. It is in these circumstances that the question referred to above arose for consideration before the Supreme Court. The Supreme Court held that in their very nature the "undivided profits" were accumulation of amounts of residue on hand at the end of the year of successive periods of accounting and these amounts were by the prevailing accounting practice and the treasury directions regarded as a part of the capital fund of the banking company. The creation and maintenance of the item known as "undivided profits" was a requirement of the Treasury Rules which were made under the statute and, therefore, it could not be said that the amount of "undivided profits" in the balance-sheet was not allocated as a result of either a resolution of the directors accepted by the shareholders, or on account of the requirements of the law. The Supreme Court, therefore, held that the amount designated as "undivided profits" was a part of the reserves and had to be taken into account when computing the capital and reserves under rule 2(1) of Schedule II to the Business Profits Tax Act. For arriving at the said conclusion, the Supreme Court applied the following observations of the Constitution Bench in Century Spinning and Manufacturing Company's case [1953] 24 ITR 499 (page 23) :
"It was held that the true nature and character of a sum disputed as reserve was to be determined with reference to the substance of the matter. The amount in dispute in that case was the profits after the deduction of depreciation and tax which amount was carried to the balance-sheet and was later recommended by the directors to be appropriated mainly to dividends and balance to be carried forward to the next year's account. Thus on the crucial date, i.e., April 1, 1946, from which the chargeable accounting period began the sum in dispute had not been declared as reserve ; on the other hand the directors had earmarked it for distribution as dividend and it remained as a mass of undistributed profits available for distribution. At page 504, Ghulam Hasan J. said :
The reserve may be a general reserve or a specific reserve, but there must be a clear indication to show whether it was a reserve either of the one or the other kind. The fact that it constituted a mass of undistributed profits on January 1, 1946 cannot automatically make 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 ......'"
16. The question as to whether "capital paid in surplus" and "earned surplus" were reserves within the meaning of rule 2(1) of the Schedule to the Business Profits Tax Act, came up for consideration before a three judges' Bench of the Supreme Court in CIT v. Standard Vacuum Oil Co. [1966] 59 ITR 685. The Supreme Court observed that in its ordinary meaning the expression "reserve" meant something specifically kept apart for future use or for a specific action. In that case, the Supreme Court, after referring to the observations in First National City Bank v. CIT [1961] 42 ITR 17, observed that it is true that the court in that case was dealing with a case of a banking company. But the characteristics noted are not peculiar to the accounts of a banking company : they are applicable with appropriate variations to the accounts of all companies, in which different nomenclatures are used in the accounts to designate the residue on hand as "surplus", "undivided profits" or "earned surplus". The Supreme Court further observed that where the balance of net profits after allocation to specific reserves and payment of dividend are entered in the account under the caption "earned surplus", it is intended thereby to designate a fund which is to be utilised for the purpose of the business of the assessee and that such a fund may be regarded according to the Indian practice as "general reserves". The balance of "earned surplus" at the end of the year did not merge into the account of the subsequent year. It represented a specific account into which were added the net profits of the year and appropriations were made out of it and the balance was regarded as "earned surplus" at the end of the year ; this account was specifically allocated for utilisation for the purpose of business year after year. It was an account in which the net profits less the appropriations were added, and the account was intended for application in extending the business of the assessee-company. The amounts entered in the account "earned surplus" cannot therefore be regarded as mere unallocated profits at the end of the accounting year.
17. The Supreme Court considered the question as to whether the appropriation of certain amounts under a scheme of gratuity by way of estimate towards liability to gratuity in the profit and loss account, amounts to a "reserve" or a "provision", in Metal Box Co. of India Ltd. v. Their Workmen [1969] 73 ITR 53. In that case, the court observed as follows (page 67) :
"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 profit and loss 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 (see Spicer and Pegler's Book-keeping and Accounts, 15th edition, page 42). An amount set aside out of profits and other surpluses, not designed to meet a liability, contingency, commitment or diminution in value of assets known to exist at the date of the balance-sheet is a reserve but 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 : (see William Pickles' Accountancy, second edition, p. 192 ; Part III, Clause 7, Schedule VI to the Companies Act, 1956, which defines provision and reserve)."
18. Again, the Supreme Court had occasion to consider the distinction between "provision" and "reserve" in Vazir Sultan Tobacco Co. Ltd. v. CIT [1981] 132 ITR 559. There, the Supreme Court was directly concerned with the question of computation of capital in the context of the provisions of the Companies (Profits) Surtax Act, 1964, and also under the provisions of the Super Profits Tax Act, 1963. In that context, the Supreme Court observed that the expression "reserve" has not been defined in the Act and, therefore, one would be inclined to resort to its ordinary natural meaning as given in the dictionary but noted that though it is useful it may not be sufficient as the dictionaries do not make any distinction between the two concepts "reserve" and "provision" while giving their primary meanings whereas in the context of the legislation with which we are concerned, a clear distinction between the two is implied. After referring to the meaning given in different dictionaries, it was observed that since the rules for computation of capital contained in the Second Schedule to the Act proceed on the basis of the formula of capital plus reserves--a formula well known in commercial accountancy, it becomes essential to know the exact connotation of the two concepts "reserve" and "provision" and the distinction between the two as known in commercial accountancy, It was further observed that though the expression "reserve" is not defined in the Act, it cannot be forgotten that it occurs in a taxing statute which is applicable to companies only and to no other assessable entities and as such the expression will have to be understood in its ordinary popular sense, that is to say, the sense, or meaning that is attributed to it by men of business, trade and commerce and by persons interested in or dealing with companies. Therefore, the meanings attached to these two words in the provisions of the Companies Act, 1956, dealing with preparation of balance-sheet and profit and loss account would govern their construction for the purposes of the two taxing enactments, The Supreme Court thereafter referred to the Constitution Bench decision in CIT v. Century Spinning and Manufacturing Co, Ltd. [1953] 24 ITR 499 (SC) and also the decision in Metal Box Co. of India Ltd. v. Their Workmen [1969] 73 ITR 53 and observed as follows (page 569) :
"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 profit and loss 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."
19. Keeping the aforesaid broad distinction in mind, the court considered how the two concepts are defined and dealt with in the Companies Act, 1956. After referring to the definitions of "provision" and "reserve" occurring in Clause 7(1)(a) and (b) and Clause 7(2) of Part III of Schedule VI to the Companies Act, it was observed as follows (page 570) :
"The effect of reading the two definitions together is that if any retention or appropriation of a sum falls within the definition of 'provision' it can never be a reserve, but it does not follow that if the retention or appropriation is not a provision it is automatically a reserve and the question will have to be decided having regard to the true nature and character of the sum so retained or appropriated depending on several factors including the intention with which and the purpose for which such retention or appropriation has been made, because the substance of the matter is to be regarded and in this context the primary dictionary meaning of the term 'reserve' may have to be availed of. But it is clear beyond doubt that if any retention or appropriation of a sum is not a provision, that is to say, if it is not designated to meet depreciation, renewals or diminution in value of assets or any known liability the same is not necessarily a reserve. We are emphasising this aspect of the matter because during the hearing almost all counsel for the assessees strenuously contended before us that once it was shown or became clear that the retention or appropriation of a sum out of profits and surpluses was for an unknown liability or for a liability which did not exist on the relevant date it must be regarded as a reserve. The fallacy underlying the contention becomes apparent if the negative and non-exhaustive aspects of the definition of reserve are borne in mind."
20. It was then observed that the question whether the concerned amounts in fact constituted "reserves" or not will have to be decided having regard to the true nature and character of the sum so appropriated depending on the surrounding circumstances particularly the intention with which and the purpose for which such appropriation has been made.
21. Again the distinction between "reserve" and "provision" in the context of the Companies (Profits) Surtax Act, 1964, came up for consideration before the Supreme Court in CIT v. Elgin Mills Ltd. [1986] 161 ITR 733. After referring to the earlier decisions in Metal Box Company's case [1969] 73 ITR 53 and Vazir Sultan's case [1981] 132 ITR 559, mentioned supra, it was held that the distinction between "provision" and "reserve" is that while "provision" is a charge on profits which are taken into account in the gross receipts of the profit and loss account, "reserve" is an appropriation of profits to provide for the asset which it represented. It was also held that investment reserve and rehabilitation reserve were reserves and were entitled to be treated as such under the relevant Act. This court in CIT v. Haileyburia Tea Estates Co. Ltd. [1995] 214 ITR 770 applied Vazir Sultan's case [1981] 132 ITR 559, mentioned supra and held that the provision for gratuity shown as reserve in the balance-sheet has to be taken into account in computing capital. This court observed that the reasoning of the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559, leads to the conclusion that the decision clearly lays down that 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 the appropriation has been made, such intention and purpose being gathered from the surrounding circumstances.
22. The Supreme Court had occasion to consider the question again in CIT v. Jyoti Ltd. [1996] 219 ITR 388. There, the question was as to whether the reserve created for meeting doubtful debts was a reserve or a provision and also as to whether gratuity reserve created by the assessee was a reserve or a provision. Regarding the doubtful debts it was noted that a clear finding of fact was reached by the Tribunal that the bad debt reserve was created out of the profit and loss account without reference to the outstanding sundry debtors and was not created with a view to meeting any anticipated liability and hence it has to be held that the said amount which was set apart for meeting bad and doubtful debts was by way of reserve and not as a provision. The court then noted the following observations in CIT v. Saran Engineering Co. Ltd. [1986] 161 ITR 741 (SC) (page 393 of 219 ITR) ; "Where the liability has actually arisen or been anticipated legitimately by the assessee though the quantum of the liability has not been determined, a fund to meet such present liability cannot be treated as a "reserve". A fund, however, created for payment of a liability which had not already arisen or fallen due but is only a provision with regard to the sum that might become liable to be paid is "other reserves" within the meaning of rule 1 of the 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."
23. The following further observations at page 744 of the said decision were also noted (page 393 of 219 ITR) ;
"Bad and doubtful debts reserve was created in 1956 through the profit and 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 as 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 the very nomenclature, this was not a reserve. The true nature of the transaction has to be examined."'
24. After adverting to the conclusion reached at page 746 of the report, it is observed as follows (page 394 of 219 ITR) :
"At page 746 of the report applying the aforesaid principles to the case on hand, it was held that in the light of the facts found so far as bad and doubtful reserves were concerned the amounts set apart must be treated as a reserve. On the facts of the present case, as noted earlier, it could not be said that there was any ascertained liability for which a provision was made by creating the aforesaid reserve for bad and doubtful debts. In the present case, it was also not the Revenue's case that the amount set apart for bad and doubtful debts reserve was less than or equal to the amount necessary to be provided for meeting ascertained liability. On the other hand, the amount appeared to be more than what was reasonably necessary to be provided for in respect of the bad and doubtful debts as the amount of bad and doubtful debts itself was not an ascertained amount. Consequently, no fault can be found with the decision rendered by the authorities below and the High Court that the provision of Rs. 85,000 for doubtful debts had to be treated as reserve which could be legitimately included in computing the capital base of the respondent-assessee-company so far as the relevant assessment years were concerned."
25. In State Bank of Patiala v. CIT [1996] 219 ITR 706, the Supreme Court considered the question as to whether amounts provided for bad and doubtful debts in the balance-sheet constitute reserve for the purpose of rule l(xi)(b) of the First Schedule and rule 1(iii) of the Second Schedule to the Companies (Profits) Surtax Act, 1964. After detailed consideration of the statutory provisions in regard to the computation of chargeable profits for the purpose of Section 4 of the Act and the decisions of the Supreme Court in Metal Box Company [1969] 73 ITR 53 ; Vazir Sultan [1981] 132 ITR 559 ; Elgin Mills [1986] 161 ITR 733 and Saran Engineering Co. [1986] 161 ITR 741, it is observed as follows (page 718) :
"A fair reading of the above decisions would go to show that if the transfer of an amount is made ad hoc, when there is no known or anticipated liability, such fund will only be treated as 'reserve'. In this case, substantial amounts were set apart as reserves. No amount of bad debt was actually written off or adjusted against the amount claimed as reserves. No claim for any deduction by way of bad debts were made during the relevant assessment years. The assessee never appropriated any amount against any bad and doubtful debts. The amounts throughout remained in the account of the assessee by way of capital and the assessee treated the said amounts as 'reserves' and not as 'provisions' designed to meet liability, contingency, commitment or diminution in the value of assets known to exist at the relevant dates of the balance-sheets. These facts have been found by the Tribunal. On the facts, the amount set apart as reserves cannot be said to be so earmarked, when any liability has actually arisen or was anticipated by the assessee. It cannot be said either, that the amounts set apart out of the profits were designed to meet any known liability, that existed at the date of the balance-sheet. Tested in the light of the decisions of this court, referred to hereinabove, it appears to us, that the amounts set apart towards bad and doubtful debts in these cases are 'reserves' qualifying for appropriate relief under rule 1(xi)(b) of the First Schedule and rule 1(iii) of the Second Schedule of the Act."
26. From the decisions of the Supreme Court discussed above, the following guiding principles emerge :
(a) A "provision" is different from "reserve". It need not necessarily follow that an amount set apart, if it is not a "provision", would automatically become "reserve".
(b) "Provisions" are charges against profits and, therefore, to be taken into account against gross receipts in the profit and loss 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.
(c) The question whether the concerned amount constitutes reserves or not will have to be decided having regard to the true nature and character of the sums so appropriated depending on the surrounding circumstances particularly the intention with which or the purpose for which such appropriation had been made.
(d) A mass of undistributed profits cannot automatically become a reserve and 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.
(e) The conduct of the assessee in dealing with the amount earmarked for the purpose during the subsistence of the same and subsequently is also relevant.
27. In the instant case, as already stated, the Tribunal in para. 5 of its order held that the assessee had obtained loans from the State Government which as on December 31, 1970, was Rs. 421 lakhs, that from 1970 to 1978 the assessee had created a "loan redemption reserve" amounting to Rs. 90 lakhs, that there was no appropriation to the said reserve in the year 1979, that there was an appropriation of Rs. 10 lakhs in the year 1980, that the total reserve amounting to Rs. 100 lakhs remained undistributed till the year 1987 and that in the year 1988 the same was transferred to the general reserve. It is also observed that from a perusal of the balance-sheet it is seen that the amount credited to the "loan redemption reserve" was not invested outside the company and that the same remained internally invested. There was also no contract between the lender and the borrower for the creation of such a reserve and the board of directors of the assessee, of its own volition, had decided to create a "loan redemption reserve" by making an appropriation from the profits of Rs. 10 lakhs every year. The Tribunal then considered the principles laid down by the Supreme Court in Vazir Sultan's case [1981] 132 ITR 559 and held that the test laid down in that case has been fully satisfied in the following manner :
"From the manner in which the reserve is created out of the profits without any obligation on its part so to do, and the fact that the funds are internally invested in the business of the assessee in contradistinction to investment outside the business and also the fact that no appropriation was made to the reserve account in the year 1979 and the ultimate transfer of the loan redemption reserve to the general reserve in the year 1988, it can be very well concluded that the guidelines laid down by the apex court in the case of Vazir Sultan's case [1981] 132 ITR 559 are very well satisfied in the case of the assessee. In point of fact, it must be stated that the amount appropriated was not against the profits but from out of the profits. Nor did the loan redemption reserve bring into existence any fresh liability because the liability was already in existence."
28. The Tribunal accordingly directed the assessing authority to include the sum of Rs. 1 crore in the capital of the company for the purposes of surtax.
29. We are in full agreement with the reasoning and conclusion reached by the Tribunal. As on the date of creation of the loan redemption reserve the assessee owed a sum of Rs. 121 lakhs towards the loan taken from the Government. There was no obligation under the contract between the Government and the assessee to create a loan, redemption reserve. The board of directors of the company had voluntarily created the reserve by making an appropriation of profit of Rs. 10 lakhs each year beginning from 1971. The appropriation of Rs. 10 lakhs every year was from out of the profits. The said reserve funds were internally invested in the business of the assessee. There was no appropriation of any amount in the reserve account in the year 1979. The entire amount of Rs. 100 lakhs in the loan redemption reserve as on December 31, 1980, was ultimately transferred to the general reserve in the year 1988. It is relevant to note that the entire amount appropriated to the loan redemption account was not against the profits but from out of the profits. It is also relevant to note that the loan redemption account was created without any reference to the loan taken from the Government. There is no case for the Revenue that any portion of the amount prior to its transfer to the general reserve was utilised for repayment of the loan amount. The only case of the Revenue is that a portion of the said amount has been utilised for clearing income-tax liability and some other liabilities. If, as a matter of fact, the intention with which this reserve fund is created, is for meeting an existing liability, the asses-see, instead of keeping the amount in the loan redemption account from 1971 to 1988 and later transferring it to the general reserve, would have paid the amount towards the loan liability especially when admittedly there was defalcation in the repayment of the loan instalments at the relevant time. The mere fact that the sum of Rs. 1 crore was kept in the loan redemption account from 1980 onwards especially when there was a huge liability to the tune of Rs. 377.50 lakhs, is proof positive of the fact that the board of directors never intended to create the "loan redemption reserve" as a provision for an existing liability. Further, as on the date when the board of directors have decided to create the said reserve fund, there was no doubt with regard to the actual loan liability to the Government. The amount due to the Government was certain as could be seen from the accounts itself. It is also a fact that the repayment of loan amounts effected during these years was not from the said fund but from other profits. According to us, the aforesaid admitted facts and circumstances will clearly show that the loan redemption reserve was not created towards any existing liability and it was created for future use only. We find that the tests laid down by the Supreme Court in the various decisions discussed above and summarised in paragraphs 10 to 19 (pages 249-260) are satisfied in the instant case. We accordingly hold that the sum of Rs. 1 crore which stood in the loan redemption reserve and was later transferred to the general reserve is a "reserve" liable to be included in the capital of the company for the purpose of surtax. We accordingly answer the questions referred to us in the affirmative, i.e., in favour of the assessee and against the Revenue.
30. A copy of this judgment, under the seal of this court and the signature of the Registrar, shall be forwarded to the Income-tax Appellate Tribunal, Cochin Bench.