The concept of reserves under the Companies (Profits) Surtax Act and the distinction between reserves and provisions.

Headnote:
Companies (Profits) Surtax Act - Computation of Capital - Reserves - Bad and Doubtful Debts - Retirement Gratuity - Stock Reserve - Interpretation and Application.
Fact of the Case:

The assessee claimed certain amounts as reserves for the purpose of computation of capital under the Companies (Profits) Surtax Act. The ITO and AAC rejected the claim, but the Tribunal allowed it in part. The Commissioner and the assessee filed references to the High Court on various issues related to the treatment of bad and doubtful debts, retirement gratuity, and stock reserve as reserves.
Finding of the Court:

1. Bad and Doubtful Debts: The Tribunal correctly distinguished between provisions for specific doubtful debts and reserves for bad and doubtful debts. The former are not reserves, while the latter are. 2. Retirement Gratuity: The Tribunal correctly held that the amounts set apart for payment of gratuity, a contingent and future liability, used for the purpose of the business of the company, were reserves. 3. Stock Reserve: The Tribunal did not properly consider whether the stock reserve represented a genuine reserve or merely a diminution of the value of the stock-in-trade. The reference on this issue was returned unanswered for reconsideration by the Tribunal.
Issues: 1. Whether the amounts deducted from the stock-in-trade for bad and doubtful debts should be treated as reserves for the purpose of computation of surtax? 2. Whether the amounts representing provisions for specific doubtful debts could be claimed as reserves? 3. Whether the reserves for bad and doubtful debts and retirement gratuity should be taken into account for the purpose of capital computation?
Ratio Decidendi: 1. Reserves: Reserves are sums specifically set apart for future use or for a specific occasion before the distribution of dividends to shareholders. 2. Bad and Doubtful Debts: Ad hoc transfers to the bad and doubtful debt reserve account qualify as reserves, while amounts taken into account as bad debts do not. 3. Retirement Gratuity: Amounts set apart for payment of gratuity, a contingent and future liability, used for the purpose of the business of the company, are reserves. 4. Stock Reserve: The Tribunal failed to consider whether the stock reserve represented a genuine reserve or merely a diminution of the value of the stock-in-trade.
Final Decision: 1. The second question was answered in the negative and against the assessee. 2. The first part of the third question was answered in the affirmative and against the revenue. 3. The second part of the third question was answered in the affirmative and against the revenue. 4. The first question was returned unanswered for reconsideration by the Tribunal.

Judgment :-

SETHURAMAN J.

In all these references, the following questions have been referred at the instance of the assessee :

"1. Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the reduction in the value of the closing stock by reason of deductions from the stock-in-trade, namely, Rs. 46, 79, 523 for 1966-67, Rs. 4, 55, 283 for 1967-68, Rs. 4, 23, 983 for 1969-70 and Rs. 4, 47, 721 is not a reserve for the purpose of computation of surtax ?

2. Whether, on the facts and in the circumstances of the case, the amounts of Rs. 11, 963 for 1966-67, Rs. 21, 801 for 1967-68, Rs. 63, 937 for 1969-70 and Rs. 89, 098 for 1970-71 representing the provisions for specific doubtful debt deducted from sundry debtors and not allowed as a deduction in the computation of income could be claimed as a reserve as per rule 1 (iii) of the Second Schedule ?

3. Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in law in holding that the reserve for bad debt and doubtful debts and reserve for retirement gratuity should be taken into account for the purpose of capital computation ?" *

We shall take up for consideration questions Nos. 2 and 3 before we go onto question No. 1. The relevant assessment came to be made under the Companies (Profits) Surtax Act. The assessment years involved are 1966-67, 1967-68, 1969-70 and 1970-71. The relevant previous years are those ending with 31st July, preceding those years, except with reference to the assessment year 1970-71 for which the previous year ended on March 31, 1970. The assessee claimed that in the computation of the capital the following amounts should be included as reserves. 1966-67-Rs. 89, 946; 1967-68-Rs. 89, 776; 1969-70-Rs. 88, 353 and 1970-71-Rs. 1, 03, 352. The ITO did not allow this claim on the ground that these were only provisions and not reserves. On appeal, the AAC confirmed the order of the ITO. The assessee appealed to the Tribunal contending that these sums have to be treated as reserves in accordance with the decision in CIT v. British India Corporation (P.) Ltd. The departmental representative, on the other hand, contended that the actual claims before the ITO for two of the years, namely, 1967-68 and 1969-70, were only Rs. 67, 975 and Rs. 24, 416, respectively. This difference was sought to be explained by stating that the reserve for bad and doubtful debts had been adjusted with reference to the provision for doubtful debts and that, therefore, there was difference in the figure claimed. The actual reserves after adjustment in the accounts were as follows : 1966-67-Rs. 78, 383; 1967-68-Rs. 67, 975; 1969-70-Rs. 24, 416 and 1970-71-Rs. 14, 254.The Tribunal took into account the explanation given by the assessee and held that the sums shown as reserves for bad and doubtful debts in the balance-sheet alone would qualify for being considered as capital. The sums deducted from the sundry debtors was considered to be a specific provision for a known liability. In this view, the Tribunal did not treat that portion as a reserve. The result was that the assessee's claim was accepted in part and rejected in part. As far as the rejection is concerned, the assessee has come forward with question No. 2 and the department has come forward with a reference to the rest of the amount having been treated as reserve by raising the third question.

The Bombay High Court in CIT v. Golder Tobacco Co. Ltd. has considered a more or less similar question. In that case the assessee followed a systematic method of transferring an ad hoc amount to the doubtful debt reserve account each year. The amount so transferred was not computed on the basis of the debts that were excepted to become bad during the relevant year or even in future. The assessee did not also claim the deduction of this amount so transferred to the reserve account in the computation of its total income nor had the ITO allowed it as a deduction. The debts whi

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