Capital gains are not automatically considered part of a company's business profits for the purpose of determining the reasonableness of dividend distribution under Section 23a of the I. T. Act, 1922. The directors' decision to treat capital gains as profits or reserves is generally respected, unless there are exceptional circumstances.

( 1 ) THE controversy in this reference arises out of proceedings taken under Section 23a of the I. T. Act, 1922, against N. Guin and Co. (P.) Ltd. , Calcutta, the assessee, in the assessment year 1960-61, the relevant previ ous year being the calendar year 1959.

( 2 ) THE facts found and/or admitted are, inter alia, that in the said assessment year the assessee was assessed to income-tax on a total income of Rs. 1,49,004. After deduction of the taxes payable the distributable surplus was found to be Rs. 1,02,323. The assessee, a private limited company, was required to distribute 65% of such surplus, i. e. , Rs. 66,510, as dividend. The assessee, however, declared a dividend of only Rs. 5,000.

( 3 ) THE assessee contended that its total income as computed included capital gains of Rs. 1,35,80. 8 which was not to be taken into account for the purposes of Section 23a, This amount was not a part of its commercial profits and had been shown in the accounts as a capital reserve.

( 4 ) THE ITO did not accept the contentions of the assessee. He found that there was no prohibition in the memorandum or the articles of the assessee which barred the distribution of such gains and that the said amount was " a surplus which had actually been realised. Holding that the assessee should have declared proportionate dividend out of the entire surplus including that arisen out of capital gains he passed an order under Section 23a levying additional super-tax on the undistributed amount.

( 5 ) BEING aggrieved, the assessee preferred an appeal to the AAC, where it was contended that under Section 205 of the Companies Act, 1956, dividend could be declared only out of profits. The expression "net profit" being defined in Section 349 of the Companies Act, no dividend could be declared out of capital gains. The AAC considered the definition of dividend in Section 2 (1 ) (a) of the Companies Act (sic) and construed that it was wide enough to include capital gains. Accordingly, he confirmed the order of the ITO.

( 6 ) THERE was a further appeal by the assessee to the Tribunal. It was brought to the notice of the Tribunal that the capital gains in question had arisen upon sale of certain land purchased long ago by way of investment. The assessee's business not being purchase and sale of land it was contended that the gains arising from sale of land could not form part of the commercial profits of the assessee and, therefore, should be excluded for the purpose of application of Section 23a. The contentions of the revenue were that capital gains formed part of the total income of the assessee and there being no restriction, either in the Companies Act or in any other statute, in distributing the same as dividend, the ITO was justified in treating this gain as part of the assessee's commercial profits.

( 7 ) THE Tribunal considered the law as laid down by the Supreme Court in CIT v. Bipinchandra Maganlal and Co. [1961] 41 ITR 290 and in CIT v. Gangadhar Banerjee and Co. (Pvt.) Ltd. [1965] 57 ITR 176. The Tribunal noted that the capital gains in the instant case had not been taken to the profit and loss account but had been credited to reserves and surplus and held that it would not be prudent business practice to distribute such gains as dividend except under special circumstances as according to recognised commercial practice such gains had to be kept in reserve for the purpose of setting off capital losses which may arise in future. The Tribunal held further that this surplus arising out of the sale of land had the character of capital investment and had been obtained by way of realisation of such capital investment which could not be converted into business profits. The Tribunal concluded that on the facts it could not be said that the dividend distributed was inadequate or unreasonable and that Section 23a had not properly been applied to the facts. The order under Section 23a was accordingly set aside.

( 8 ) AT the instance of the CIT,