Rayon Corporation Ltd. Vs. The Commissioner of Income Tax  INSC 624 (29
C. SEN, K. T. THOMAS
C.A NOS. 2/95, 198/89, 432/89, 433/89 AND 2970/81)
point that falls for determination in this case is whether a sum of Rs. 79 lakhs
representing Debenture Redemption Reserve was includible in computing the
capital of the assessee Company for the purpose of Companies (Profits) Surtax
High Court took the view that the amount set apart to redeem the debentures has
to be treated as 'provision' and not as 'reserve'. The facts stated by the High
Court in this regard are as follows:
the balance-sheets for the said periods, we find that in the calendar year
1965, the development rebate reserve was Rs. 79,00,000.
in the next calendar year 1966, which is relevant to the assessment year
1967-68, the figure of debenture redemption reserve has gone up to Rs.
1,12,00,000. A perusal of the balance-sheet further shows that the assessee company
had floated an actually issued 6 1/2 per cent secured redeemable mortgage
debentures, as pointed out earlier, against the security of land, buildings and
machinery of the company and a floating charge on the undertaking.
of these debentures appear to have been redeemed during the relevant previous
years. There is no dispute regarding any of these facts. In these
circumstances, it clearly appears to us that the debenture redemption reserve
must be regarded as a provision made by the assessee company to enable it to
redeem the said debentures when they became due for redemption.
the aggregate amount o such debentures is much larger than the amount of the
debenture redemption reserve, we fail to see how it can be said that there was
any excess as such in this appropriation which could be taken as reserve. It is
true that all the debentures had not become redeemable during the relevant
previous years, but that does not make any difference because an amount set
aside to meet a future liability, which was certain to come into existence, as
in this case, must be regarded as a provision and not as a reserve." We
are of the view that the High Court has come to a correct conclusion. The basic
principle is that an amount set apart to meet a known liability cannot be
regarded as 'Reserve'. 'Provision' and 'Reserve' have been defined in Part III,
Schedule VI of the Companies Act itself:
(1) For the purposes of Part I and II of this Schedule, unless the context
otherwise requires,- (a) the expression "provision" shall, subject to
sub-clause (2) of this Clause, mean any amount written off or retained by way
of providing for depreciation, renewals or diminution in value of assets, or
retained by way of providing for any known liability of which the amount cannot
be determined with substantial accuracy:
the expression "reserve" shall not, subject as aforesaid, include any
amount written off or retained by way of providing for depreciation, renewals
or diminution in value of assets or retained by way of providing for any known
the expression "capital reserve" shall not include any amount
regarded as free for distribution through the profit and loss account; and the
expression revenue reserve shall mean any reserve other than a capital reserve;
this sub-clause the expression "liability" shall include all
liabilities in respect of expenditure contracted for and all disputed or
Where- (a) any amount written off or retained by way of providing for
depreciation, renewals or diminution in value of assets, not being an amount
written off in relation to fixed assets before the commencement of this Act; or
(b) any amount retained by way of providing for any known liability;
excess of the amount which in the opinion of the directors is reasonably
necessary for the purpose, the excess shall be treated for the purposes of this
Schedule as a reserve and not as a provision.
definition clearly indicates that if an amount is retained by way of providing
for any known liability that amount shall not be treated as reserve. Clause
7(2)(b) makes it clear that only an amount which is in excess of what is
reasonably necessary for meeting a known liability shall be treated as reserve
and not as provision. The directors will have to form an opinion as to what is
reasonably necessary for meeting the known liability of a Company. The opinion
of an accountant or an auditor or a lawyer is quite immaterial for this
finding of fact in this case is that the amount set apart for redemption of
debentures is less than the Company's liability on this account. Therefore, the
answer to the question raised must be that the amount of Rs. 79 lakhs
representing Debenture Redemption Reserve cannot be included in the capital of
the Company for the purpose of Surtax assessment. The facts stated in the
judgment of the High Court go to show that the amount was not larger than the
amount which had to be paid for redemption of the debentures. Therefore, there
is no question of any excess provision in this case.
case of Vazir Sultan Tobacco Co. Ltd. V. Commissioner of Income Tax, A.P., 132
I.T.R. 559, it was held that 'provision' and 'reserve' had not been defined
under the Companies (profits) Surtax Act, 1964. Therefore, the two concepts
'reserve' and 'provision' which are fairly well known in commercial accountancy
and which are used under the Companies Act dealing with preparation of Balance
Sheets and Profit and Loss Accounts, will have to be gathered from the meaning
attached to them by the Companies Act itself. Moreover, in Vazir Sultan's Case,
it was pointed out that even if a sum of money which had been set apart for a
certain purpose was held not to be a 'provision', it did not automatically
follows that it would be a reserve. It was held:
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 re 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 surplus 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." It has been contended by Shri T.A. Ramachandran on behalf
of the assessee that what is set apart for meeting the current year's known or
estimated liability will be 'provision'. An amount set apart for future use
will not be 'provision'. This argument is without any merit. It goes against
the very definition of 'provision' and 'reserve' provided by the Companies Act.
in the form of Balance Sheet in Schedule VI of the Companies Act provisions
have to be made, inter alia. for Contingencies, Provident Fund Scheme,
insurance, Pension and Staff benefit schemes. Amounts set apart for the
aforesaid purposes will mostly be for future use. Question of payment of
pension or provident fund can only arise when an employee retires.
advanced another argument that there was no present liability to pay any amount
to the debenture- holders. That liability will arise only when the amount falls
due for payment. Therefore, there was no existing liability for redeeming the
debentures in the relevant year of account.
unable to uphold this argument. The liability to repay arises the moment the
money is borrowed. The amount borrowed may be repayable immediately or in
date of repayment of loan may be deferred by agreement but the obligation or
the liability to repay will not cease on that account. The obligation is a
in Praesenti, solvendum in futuro. This aspect of the matter was explained in
the judgment of this Court in Kesoram Industries and Cotton Mills Ltd., v. The
Commissioner of Wealth Tax (Central), Calcutta, A.I.R. 1996 SC 1370.
issuing the debentures, the company had taken a loan against the security of
its assets. This loan may not be repayable in the year of account. But the
obligation to pay the loan is a present obligation. Any money set apart in the
accounts of the company to redeem the debentures must be treated as moneys set
apart to meet a known liability. The debentures will have to be shown in the
Company's Balance Sheet of the year as 'Liability'.
case of Commissioner of Income Tax vs. Peico Electronics 7 Electricals. 166 ITR
299, the Calcutta High Court held that the debenture redemption reserve will
have to be treated asa 'reserve' and not 'provision' because, none of the
debentures became redeemable during the accounting period. The liability to
redeem the debentures was a future liability. The debentures had been
separately shown in the balance sheet as a liability. The reserve had been
created by appropriation of profits and not by way of a charge on revenue.
of the view that this approach is erroneous and overlooks the definitions of
'provision' and 'reserve' given ion the Companies Act. The debentures were
nothing but secured loans. Merely because, the debentures were not redeemable
during the accounting period, the liability to redeem the debentures did not
cease to exist. It was redeemable or repayable at a future date. But is was a
known liability. In the form of balance sheet prescribed by the Act in Schedule
VI, the secured loans have to be shown under the heading 'liabilities'. Secured
loans have to be shown under the heading 'liabilities'. Secured loans include
(1) debentures, (2) loans and advances from banks.
and advances from subsidiaries and (4) other loans and advances. The secured
loans might not be immediately repayable, but the liability to repay these
loans was an existing liability and has to be shown in the Company's Balance
Sheet for the relevant year of account as a liability. Amount set apart to pay
these loans cannot be 'reserve'. The interpretation clause of the Balance Sheet
in Schedule VI of the Companies Act specifically lays down that reserves shall
not include any amount written off retained by way of providing for a known
Delhi High Court in the case of Commissioner of Income Tax v. Modi Industries
Ltd. (No.2), 197 ITR 655 also took the view that the amount set apart out of
profits to redeem the debentures had to be treated as reserves because, there
was no liability in the current year to redeem the debentures.
unable to agree with this view for the reasons given earlier in the judgment.
from this, the argument that found favour with the Courts in the cases of Peico
Electronics & Electricals and Modi Industries Ltd. (supra) that if the
retention or appropriation of a sum of profits and surpluses was for an unknown
liability of for a liability which did not exist on the relevant date it must
be regarded as a 'reserve', was specifically rejected by this Court in Vazir
Sultan's Case (supra). This argument of the assessee was held to be fallacious
(Page 571 of the report).
is another aspect of this case. In the prescribed form of Balance Sheet, under
the heading "RESERVES AND SURPLUSES" seven types of reserves have to
Capital Reserves, (2) Capital Redemption Reserve, (3) Share Premium Account (4)
Other reserves, (5) Surplus, i.e., balance in profit and loss account.
Proposed additions to reserves.
for the purpose of computation of capital of a company under the Companies
(Profits) Surtax Act, 1964, items 5,6 and 7 will not be treated as Reserves.
The Second Schedule of the Surtax Act lays down the rules for computation of
the capital. Rule 1 contains an Explanation to the following effect:
- 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 1st 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." In Batliboi's
advanced Accountancy, 27th Edn. p.678, the nature of a Sinking Funds is
explained as under;
Fund. - A Sinking Fund is a fund created with the object of providing means for
the redemption of liabilities like debentures or any other loan. It is formed
by setting aside, half yearly or yearly, a fixed sum of money for a definite
period, such sum to be invested at compound interest, so that at the end of the
period, the annual amounts, with accumulations of interest, will be sufficient
to discharge a prescribed loan. In such a case, the amount set aside should not
be debited to Revenue Account but to a Net Revenue Account or Profit and Loss
Appropriation Account, as being rather in the nature of an allocation of
profits than a charge against them." A Sinking Fund created for redemption
of debentures will not be treated as Reserve even though (1) it has to be shown
as "Reserve" in the Balance Sheet and (2) the amount kept in this
fund is in the nature of allocation of profits and not a charge against them.
It is difficult to see, in the context of this rule in the Second Schedule, why
a Debenture Redemption Reserve is to be treated as "Reserve" on the
ground that the amounts set apart for redemption of debentures are not in the
nature of a charge against profits but merely appropriation of profit. In Peico
Electronics & Electricals Case (supra), one of the grounds which weighed
with the Court was the argument that the Sinking Fund has to be utilised by
making investments and did not form part of the working capital of the Company
but the amount lying to the credit of Debenture Redemption Reserve was
available to the Company to used as working capital.
fail to comphrehend this distinction. what has to be computed under Rule 1 of
the Second Schedule of the Surtax Act is the capital of the Company and not its
working capital. The amount shown as Sinking Funds may be invested in a
fruitful way so that the principal and gains from the investments taken
together will enable the Company to pay off its debts. Investment of monies
standing to the credit of the Sinking Fund is nothing but utilisation of the
Company's assets for the discharge of its liabilities.
is no rational explanation why a Sinking Fund for redemption of debentures will
not be a reserve but a Debenture Redemption Reserve created with the same
purpose will be treated as reserve and included in computation of capital of
the Company for surtax purposes. A construction which leads to absurdity should
basic principle is that any amount retained by way of providing for a known
liability will not be 'reserve'.
to Rule 1 of the Second Schedule of the Surtax Act takes this principle to its
logical conclusion by providing that even a Sinking Fund, which has to be shown
as a reserve in the prescribed form of balance Sheet, will not be treated as
'Reserve' for the purpose of computation of capital.
further to be noted that the surplus and unallocated balance in the Profit and
Loss Account has been specifically excluded from "reserves" for
computation of capital under the Surtax Act. Therefore, availability of the
amount for utilisation as working capital of the Company or for distribution of
dividend cannot be a criterion for deciding whether a particular amount
retained from the profits of the Company will be treated as its reserve or not.
premises, we are of the view that the judgment under appeal; was rightly
decided. We are unable to uphold the contrary decisions in the cases of Peico
Electronics & Electricals and Modi Industries Ltd. (supra).
appeal is, therefore, dismissed. There will be no order as to costs.
APPEAL NOS.2/95, 198/89, 432/89 AND 433/89 Appeals are dismissed in view of the
will be no order as to costs.
Appeal No 2970/81 In this appeal, we are concerned with the following question;
on the facts and in the circumstances of the case, the sums of Rs. 38,98,970/-
and Rs. 6,66,159/- constituted reserve and was required to be taken into
account in the computation of the capital under the Super Profits Tax Act,
1963" However, we are concerned in this appeal only with the amount of Rs.
6,66,159/- which was appropriated to gratuity reserve. The question is whether
this should be treated as reserve or provision. The point is well settled by
the decision of this Court in the case of Vazir Sultan (supra).
answer to the question will be that the amount of Rs. 6,66159/- will have to be
treated as provision and not reserve. We answer the question accordingly. The
order of the High Court to the above extent is set aside.
point has been taken on behalf of the respondents that the amount was more than
what was actually required to be set apart as liability for gratuity. We are
not expressing any opinion as to that because that is a question of fact. It
does not appear from the High Court's order or the question raised that this
point was at all in issue before the Court or the Tribunal.
can raise this question, it can lawfully do so, before the Tribunal. The appeal