Commissioner of Income Tax vs Lakshmi Mills Company Ltd.

Thanikkachalam, J.—At the instance of the Department, the Tribunal referred the following question for the opinion of this court u/s 256(2)

of the Income Tax Act, 1961 :

Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that the debenture redemption reserve

created by the assessee is not a ''provision to meet a known liability'' but is a ''reserve'' to be taken into account for capital computation under the

Companies (Profits) Surtax Act, 1964 ?

The assessee-company had issued 35,000 debentures of Rs. 100 each, totalling Rs. 35,00,000. The assessee executed a debenture trust deed

on December 28, 1970, which provided for creation of a debenture redemption reserve. As on the 1st day of the previous year relevant for the

assessment year 1974-75, the reserve had accumulated to Rs. 15,00,000. While completing the surtax assessment, the Income Tax Officer held

that it is only a provision to meet a known liability and hence it is not a reserve to be includible in the capital base. On appeal, the Commissioner of

Income Tax (Appeals) also agreed with the Income Tax Officer. In further appeal by the assessee, the Appellate Tribunal held that as per clause

20 of the debenture trust deed, the assessee was empowered to utilise the aforesaid amount for the purpose of its business and hence the money

cannot be said to have been set apart to meet a known liability. The Tribunal, therefore, came to the conclusion that the debenture redemption

reserve should be treated as a ""reserve"" for the purpose of capital computation.

Learned standing counsel for the Department submitted that it is a provision made to meet a known liability. The debenture redemption reserve

is in fact a reserve created to meet a liability, viz., the redemption of the debenture. In view of the decision of the Supreme Court in the case of

Metal Box Company of India Ltd. Vs. Their Workmen, , the debenture redemption reserve is not a reserve, since it does provide for a known

liability. The fact that the debenture redemption reserve could be utilised by the company before the actual redemption of the debenture is not

really material to the issue arising in this case.

However, learned counsel appearing for the assessee submitted that the Explanation to rule 1 of the Second Schedule is not applicable to the

debenture redemption reserve. Items Nos. (5), (6) and (7) under the heading ""Reserves and surplus"" in the column relating to liabilities in the form

of balance-sheet given in the Part I of Schedule VI of the Companies Act, 1956, are as under :

(5) Surplus, i.e., balance in profit and loss account after providing for proposed allocations, namely :-

Dividend, bonus or reserves

(6) Proposed additions to reserves

(7) Sinking funds.

It was pointed out that the above item, viz., debenture redemption reserve does not fall in any of the categories comprised in items Nos. (5), (6)

and (7) referred to above. It was also pointed out that under the terms of the issue the debenture redemption reserve and the provisions of the

debenture redemption trust deed the assessee is not required to create a debenture redemption fund but only a debenture redemption reserve. If a

debenture redemption fund has been created there would have been corresponding assets in the balance-sheet investments representing those

funds. Such is not the case here and, therefore, the debenture redemption reserve of Rs. 15,00,000 is of the nature of reserve not falling under

items (5), (6) and (7).

As on the first day of the previous year relevant to the assessment year 1974-75, the reserve had accumulated to Rs. 15 lakhs. The Income Tax

Officer and the Commissioner of Income Tax (Appeals) held that it is only a provision to meet a known liability and hence not a reserve includible

in the capital base. The question is whether the debenture redemption reserve for Rs. 15 lakhs is a reserve to be taken into account for capital

computation.

The assessee-company had issued 35,000 debentures of Rs. 100 each total being Rs. 35 lakhs. The issue is made in terms of a debenture trust

deed dated December 28, 1970, made between the assessee and the Central Bank Executor and Trustee Company Limited. The assessee-

company is to redeem 1/4th of the debentures on May 31, 1976, and further 1/4th next year and so on. The trust deed also provided for the

creation of a reserve. The relevant clauses are as follows :

The company shall create and maintain an account called debenture redemption reserve as from 31st March, 1971. The company will in the

financial year 1970-71 (i.e., year commencing from 1st April 1970, and ending with 31st March, 1971), and in every subsequent financial year

thereafter till the financial year ending 31st March, 1977, transfer a sum of Rs. 5,00,000 per year to the debenture redemption reserve. Provided

that if the company transfers to the debenture redemption reserve a sum of Rs. 5 lakhs in any financial year, such excess shall be adjusted in any

subsequent year or years towards transfers to be made to the debenture redemption reserve, in such subsequent year or years.

The company shall be entitled to use the moneys standing to the credit of the debenture redemption reserve, for redemption of debentures as

provided as clauses 4 and 5 hereof for the company''s business purposes.

The Bombay High Court in Commissioner of Income Tax Vs. National Rayon Corporation Ltd., , while considering the nature of debenture

redemption reserve held that, ""a perusal of the balance-sheet of the company showed that it had floated and actually issued 6 1/2 per cent.,

redeemable mortgage debentures. None of these debentures appeared to have been redeemed during the relevant previous years. In these

circumstances, the debenture redemption reserve had to be regarded as a provision to enable the company to redeem its debentures. Since the

aggregate amount of such debentures was much larger than the debenture redemption reserve, it could not be said that there was any excess as

such in this appropriation which could be taken as a reserve. Hence, the sum of Rs. 79 lakhs representing the debenture redemption reserve was

not includible in the capital of the company for purposes of surtax.

In Commissioner of Income Tax, Kanpur Vs. Elgin Mills Ltd., Kanpur, , the Supreme Court 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 profit to provide for the asset which it represented"".

In Commissioner of Income Tax Vs. Modi Industries Ltd., in a case where the assessee which had issued two sets of debentures created, by

appropriation of profits from profit and loss appropriation account, a reserve called the ""Debenture Redemption Fund"", there was no liability of the

current year which had to be met by those funds in redeeming debentures, in that year, and the funds had been set apart for use only in future, the

Delhi High Court held that, ""the debenture redemption fund was a ''reserve'' and had to be included in the capital base for the purpose of the

Companies (Profits) Surtax Act, 1964"".

In Commissioner of Income Tax Vs. Peico Electronics and Electricals (Formerly Philips India Ltd.), , the Calcutta High Court held that, ""the

debenture redemption reserve in the instant case fulfilled the test of a reserve because (a) the reserve had been created out of appropriation from

profits and not by way of a charge on the revenue; (b) the fund had been retained to form part of the capital employed in the business, i.e., it had

not been invested in securities or otherwise so as to take it out of the business; (c) none of the debentures became redeemable during the

accounting period. The liability to redeem the debentures was a future liability; and (d) the debentures had been separately shown in the balance-

sheet as a liability. The debenture redemption reserve had not been converted into a sinking fund by investment. Therefore, the Tribunal was right

in holding that the debentures redemption fund could not be excluded in computing the capital of the assessee for the purpose of surtax.

So also in the case of Commissioner of Income Tax Vs. National Rayon Corporation Ltd., , the Bombay High Court held that, ""the debenture

redemption reserve does not constitute a reserve for purposes of rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964."" In

the abovesaid decision, the Bombay High Court after going through several decisions of the Supreme Court on this aspect held as under (page

579) :

We have gone through the above three decisions of the Supreme Court as well as the Calcutta and Karnataka High Courts'' decisions relied on

by Shri Mehta carefully. No doubt, there is an observation in the Supreme Court decisions that a provision is a charge against profits. It is,

however, seen that in Commissioner of Income Tax, U.P. Vs. Laxmi Sugar and Oil Mills Ltd., , the Supreme Court referred to its earlier decision

in Vazir Sultan Tobacco Co. Ltd., Hyderabad and Others Vs. Commissioner of Income Tax, Andhra Pradesh, Hyderabad, . In that case, the

Supreme Court had referred to its still earlier decision in the case of Metal Box Company of India Ltd. Vs. Their Workmen, , wherein a reference

was made to a quotation from Spicer and Pegler''s Book-keeping and Accounts. The headnote of the case is, thus, to that extent, not very correct.

Moreover, in those very decisions, the question of forfeited dividend reserve had come up for consideration and it was held that such a reserve

was not to be treated as a reserve. It is needless to mention that dividends are never a charge against profits. They are distributed out of the profits

after the profits are computed. In its decision in Vazir Sultan Tobacco Co. Ltd., Hyderabad and Others Vs. Commissioner of Income Tax, Andhra

Pradesh, Hyderabad, , also the Supreme Court examined the meaning of ''reserve'', inter alia, in the context of the dividend. In the circumstances, it

is not possible to accept that our court''s judgment in the assessee''s own case in Commissioner of Income Tax Vs. National Rayon Corporation

Ltd., has been even impliedly overruled by the Supreme Court. As regards the Karnataka and Calcutta High Court decisions, we find that in both

the cases the reserve was for the redemption of preference shares. Whether preference shares should or should not be redeemed is a right vested

in the company and not in the shareholders whereas in the case of debentures, the right to get debentures redeemed vests in the debenture-holders.

The two cases are, therefore, not applicable in the facts of this case.

Accordingly, following our judgment in the assessee''s own case in Commissioner of Income Tax Vs. National Rayon Corporation Ltd., , we

would hold that the debenture redemption reserve is not a reserve and answer the second question in the negative and in favour of the Revenue.

We will also answer the third question in the negative and in favour of the Revenue subject only to this that when the matter goes back to the

Tribunal for passing an order in accordance with the judgment of this court, the Tribunal will consider whether the gratuity reserve of Rs. 17 lakhs

is in excess of the assessee''s actual gratuity liability on actuarial basis and the excess, if any, will be treated as reserve.

In Commissioner of Income Tax Vs. Sijua (Jheriah) Electric Supply Co. Ltd., , while considering the provisions of the Companies (Profits)

Surtax Act, 1964, Schedule II, the Calcutta High Court held that : ""where a debenture redemption reserve was created out of the profits of the

company and the payment to the debenture-holders on account of principal and interest was made out of funds other than the debenture

redemption reserve account and an amount equal to the cash applied in redeeming the debentures was transferred from the profit and loss account

to the capital redemption reserve fund in order to conserve working capital, i.e., to prevent reduction of capital, in such a case, the debenture

redemption reserve is a reserve and not a provision and is to be taken into account for computing capital for purposes of surtax under Schedule II

of the Companies (Profits) Surtax Act, 1964.

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.... 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.

According to clause 20 of the debenture redemption trust deed in the present case, the company shall be entitled to use the moneys standing to the

credit of the debenture-redemption reserve, for redemption of debentures as provided in clauses 4 and 5 hereof for the company''s business

purposes. Clause 20 shows that the assessee-company will be entitled to utilise the amount till the 1st day of redemption date of May 31, 1976,

amounts covered by the company''s business purposes. So till that date this amount is available to the company as of right for purposes of

business, i.e., the provision in the trust deed. The fact that the company could use the debenture redemption reserve fund till the redemption date is

a vital fact in the present case as otherwise the debenture redemption reserve in the present case is having the character of a provision. The right to

use the said fund before the date of redemption is the fact which makes the difference in the present case. It is that fact, the right of user, that

makes all the difference and when the right of the assessee to use it for business purposes is assured and protected, it is not possible for us to say

that it has been set apart to provide for a known liability. It was also further pointed out that when an amount was set apart to provide for a known

liability businessmen would ordinarily plough it back to use for purposes of business. If the right to plough back is there, then it ceases to be a

provision to meet a known liability. So in the light of the fact of right of user contained in clause 20, the debenture redemption reserve is a reserve

and not a provision, according to the Tribunal. Thus, considering the peculiar facts arising in this case, in the light of the judicial pronouncements

cited supra, we hold that there is no infirmity in the order passed by the Tribunal in coming to the conclusion that the debenture redemption reserve

fund in the present case is only a reserve and not a provision and that it should be included in the capital base. Accordingly, we answer the

question referred to us in the affirmative and against the Department. No costs.