# [1966] 2 S.C.R. 367

- **Citation:** [1966] 2 S.C.R. 367
- **Court:** Supreme Court of India
- **Decided:** 1965-10-26
- **Bench:** K. SUBBA RAo, J. C. Shah, S. M. S!Kri
- **Source:** https://unisonlegal.in/judgment/supreme-court-of-india/1966-2-s-c-r-367-3558
- **Pages:** 17

## Headnote

Business Pro.fits Tax Act, 1947- Schedule 1/, rules 2(1) and (3)-
"Premium" and "reserv,es" in conzputation of capital under r. 2(1)-
Whether cover accounts described as "capital paid in surplus" and "Earned
Surplus'' according 10 American accounting practice.
The assessee company was incorporated in the State of Delaware in
the United States of America with the object of taking over the assets of
two other American companies in return for stock in the assessce. company.
Upon the acquisition, although the book value of the assets taken over
from each of the two transferor companies was different, the two companies were allotted an equal number of shares in ·the assessee company.
Part of this difference was covered by issuing serial bonds .to one of the
companies which were ]ate redeemed.
As the total
book-value of the
assets taken over by the assessee company was in excess of the par value
of the slock issued to the two transferor companies,
this
excess, in
accordance with e:stablished accounting practice in the United States of
America, was entered in the books of the
asses-see
C'01npany
in
an
account styled "Capital paid in Surplus".
The net p1ofits earned by the assessec company from year to year,
after certain appropriations, were also in Jine with American accounting
practice, 5hown in the balance sheet under the caption "f...1rncd s11rplils"
or "Earnings reinves.ted".
In proceedings for asse:ssment under s. 4 of the Business Profits Tax
Act, 1947. the Income Tax Officer disallowed the claim of thei asscssee
company for the. inclusion of the accounts "Capital paid in Surplus" and
"Earned Surplus" in the computation of taxable capital under Schedule II
r. 2(1) of the Act and the Appellate Assistant Commissioner agreed with
him.
But the Tribunal, in appeal, held that the difference between the
value of the assets taken over· and the value of stock issued by the asscssee
company was premium realised from the issue of its shares and retained
in the business within the meaning pf rule 3 of Sch. II and was in any
event reserve not alloW'Cd in computing profits within the meaning of
r. 2(1). The Tribunal also held that the "Earned Surplus" represented
reserves liable to be taken into account in assessing business profits tax.
Upon a reference, the High Court agreed with the views of the Tribunal.
It was contended on behalf of the Revenue, inter alia, (i) that shares
may be said to Jbe issued at a premium only when they were issued for
cash in excess of par value and not otherwise; (ii) that the amount of
"Capital paid. in Surplus" could not be regarded as· "reser'i1cs.'' as the reserves contemplated by r. 2(1) are only those which are built out of pm-
.fits processed for the purpose of taxation under the Indian Income-tax
H
Act and that where a reserve is brought into existence by creating or
increasing, by revaluation or otherwise a book asset, it cannot be included
in the computation of capital by virtue. of the Explanatiop to r. 2; (iii)
that the "Earned Surplus" in the balance sheets of the assessce company
L2Sup. CI/66-10
368
SUPREME COURT REPORTS
[1966] 2 s.c.R.
were not reserves, as accumulated profits could only be deemed reserves
within the meaning or r. 2(1) if they were
specifically
allocated to
reserves and not otherwise.
HELD : (i) The High Court was right in holding that the difference
between the book value of the assets transforred and the par value
of
capital stock was premium. [376 E]
In the absence of any restriction in the law of Delaware against the
issue of shares otherwise than for cash, when shares were issued for consideration other than cash, the value of assets transferred in exoess of the
par value of shares issued would be regarded as "premium' under the
Indian system of law. [374 F]
When shares are issued at a premium. ordinarily premium at a uniform rate would be charged from all applicants for shares; but on principle there is no objection to the charging of varying rates of premium for
shares is

## Text

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A
THE COMMISSIONER OF INCOME TAX (CENTRAL)
CALCUTTA
v.
B
STANDARD VACUUM OIL COMPANY
October 26, 1965
c
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G
[K. SUBBA RAo, J. C. SHAH AND S. M. S!KRI, JJ.J
Business Pro.fits Tax Act, 1947- Schedule 1/, rules 2(1) and (3)-
"Premium" and "reserv,es" in conzputation of capital under r. 2(1)-
Whether cover accounts described as "capital paid in surplus" and "Earned
Surplus'' according 10 American accounting practice.
The assessee company was incorporated in the State of Delaware in
the United States of America with the object of taking over the assets of
two other American companies in return for stock in the assessce. company.
Upon the acquisition, although the book value of the assets taken over
from each of the two transferor companies was different, the two companies were allotted an equal number of shares in ·the assessee company.
Part of this difference was covered by issuing serial bonds .to one of the
companies which were ]ate redeemed.
As the total
book-value of the
assets taken over by the assessee company was in excess of the par value
of the slock issued to the two transferor companies,
this
excess, in
accordance with e:stablished accounting practice in the United States of
America, was entered in the books of the
asses-see
C'01npany
in
an
account styled "Capital paid in Surplus".
The net p1ofits earned by the assessec company from year to year,
after certain appropriations, were also in Jine with American accounting
practice, 5hown in the balance sheet under the caption "f...1rncd s11rplils"
or "Earnings reinves.ted".
In proceedings for asse:ssment under s. 4 of the Business Profits Tax
Act, 1947. the Income Tax Officer disallowed the claim of thei asscssee
company for the. inclusion of the accounts "Capital paid in Surplus" and
"Earned Surplus" in the computation of taxable capital under Schedule II
r. 2(1) of the Act and the Appellate Assistant Commissioner agreed with
him.
But the Tribunal, in appeal, held that the difference between the
value of the assets taken over· and the value of stock issued by the asscssee
company was premium realised from the issue of its shares and retained
in the business within the meaning pf rule 3 of Sch. II and was in any
event reserve not alloW'Cd in computing profits within the meaning of
r. 2(1). The Tribunal also held that the "Earned Surplus" represented
reserves liable to be taken into account in assessing business profits tax.
Upon a reference, the High Court agreed with the views of the Tribunal.
It was contended on behalf of the Revenue, inter alia, (i) that shares
may be said to Jbe issued at a premium only when they were issued for
cash in excess of par value and not otherwise; (ii) that the amount of
"Capital paid. in Surplus" could not be regarded as· "reser'i1cs.'' as the reserves contemplated by r. 2(1) are only those which are built out of pm-
.fits processed for the purpose of taxation under the Indian Income-tax
H
Act and that where a reserve is brought into existence by creating or
increasing, by revaluation or otherwise a book asset, it cannot be included
in the computation of capital by virtue. of the Explanatiop to r. 2; (iii)
that the "Earned Surplus" in the balance sheets of the assessce company
L2Sup. CI/66-10
368
SUPREME COURT REPORTS
[1966] 2 s.c.R.
were not reserves, as accumulated profits could only be deemed reserves
within the meaning or r. 2(1) if they were
specifically
allocated to
reserves and not otherwise.
HELD : (i) The High Court was right in holding that the difference
between the book value of the assets transforred and the par value
of
capital stock was premium. [376 E]
In the absence of any restriction in the law of Delaware against the
issue of shares otherwise than for cash, when shares were issued for consideration other than cash, the value of assets transferred in exoess of the
par value of shares issued would be regarded as "premium' under the
Indian system of law. [374 F]
When shares are issued at a premium. ordinarily premium at a uniform rate would be charged from all applicants for shares; but on principle there is no objection to the charging of varying rates of premium for
shares issued under a single resolution, if all the parties concerned agree.
In the present case although the book value of the assets transferred by
the transferor companies was larger than that of the assets transferred
by the other company, these two companies agreed with the assessee company to receive stocks of equal par value carrying equal rights. [374H;
375E]
Shares at or without premium may be issued subject to express statutory
provision to the contrary for money or services or in consideration of
transfer of property. There was no provision in the companies Act, 1913,
nor. was any shown in a statute in the State of Delware which enacted a
different rule. (376 A-BJ
(ii) The amount of "capital paid
in
surplus"
also
represented
"reservc.s" within the meaning or r. 2(1).
A
B
c
D
Reserves built up from sources other than profits would be admissible
E
for inclusion in capital under r. 2(1)
Conin1issioner of lneome-tax, Bombay v. Century Spinning & Manufacturing Co. Ltd., 24 J.T.R. 499, referred to.
Difference between the assets received by the company and the par
value of the shares issued was not a book asset "brought into existence by
creating or increasing (by valuation or otherwise)". These assets received
by the assessee company were real and tangible assets and it was only
F
for accountancy purposes that a part of the value of assets was allocated
to the par value of the shares and the balance to the "Capital pairl in
Surplus" accoμnt. [378 A-DJ
.(iii) The High Court was right in holding that the "Earned Surplus"
in the assessee company's accounts represented "reserves" within the meaning of r. 2(1).
·
In accordance with accountancy practice in the United States of
America, the balance of net profits after allocation to specific re&erves
and payment of dividend is entered in the account under the caption
"Earned Surplus" and it is intended thereby to designate a fund which
is to be utilised for the purpose of the business. Such a fond may be
regarded according to the Indian practice as "general reserves".
First National City Bank v. Commissioner of Jncome-tax, Bo1nbay,
42. I.T.R. 17. referred to.
The accounts of the a'iSeSSee eompany maintained according to the
general accouniancy practice prevailing in the United States of America
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C.I.T. V. STANDARD VACUUM (Shah, J.)
369
disclosed that 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 \verc added the net profits o~ the year and
appropriations were. made out of it and the balance Y..'as regarded as
""Earned Surplus" at the e.nd of the year.
'[his account \Vas specifically
allocated for utilisation for the purpose of the business year after year.
Therefore the conditiDns regarded as essential in the Century Spinning
& Manufacturing Company's for constituting the "Earned Surplu::;" into
"reserves" were fulfilled. [379G-383E-G]
CIVIL APPELLATE JURISDJCTION: Civil Appeal No. 268 of
1964.
Appeal by special leave from the judgment and order dated
January 29, 1962 of the Calcutta High Court in Income-tax Rec ference No. 18 of 1955.
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A. V. Viswanatha Sastri, N. D. Karkhanis, R. H. Dhebar and
R. N. Sachthey, for the appellant.
N. A. Palkhiwa!a, Ramachandran, J. B. Dadachanji, 0. C.
Mathur and Ravinder Narain, for the respondent.
The Judgment of the Court was delivered by
Shah, J.
At the instance of the Commissioner of Income-tax
(Central) Calcutta, the Income-tax Appellate Tribunal referred the
following questions for the opinion of the High Court of Calcutta
under s. 19 of the Business Profits Act 21of1947:
"(l) Whether on the facts found the Tribunal was
right in holding that the sum of $117,000,000 appearing in the Balance Sheet of the assessee Company under
the head "Capital paid in Surplus" and constituting the
excess of the book value of the assets over the face value
of the shares represented premium realised from the issue
of the shares as contemplated by Rule 3 of Schedule II
of the Business Profits Tax, Act, 1947.
(2) Whether on facts and i11 the circumstances of
the case the Tribunal was right in holding that the fact
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that the amount in question had been built up out of
capital and not out of taxed profits would not prevent it
from being reserve as contemplated by Sub-Rule (1) of
Rule 2 of the Schedule II of the Business Profits Tax Act.
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(3) Whether on the facts and in the circumstances of
the case, the Tribunal was right in holding that the sum
of $29,000,000 odd, $43,000,000 odd, $56,000,000
odd and 73,000,000 & odd for the respective years
appearing in the Balance Sheets of the assessee as
370
SUPREME COURT. REPORTS
[1966] 2 S.C.R.
"Earned Surplus" would be treated as a reserve within
A
the meaning of Sub-Rule ( 1) of Rule 2 of the Schedule II of the Business Profits Tax Act."
The High Court recorded answers in the affirmative on all the
questions. The Commissioner of Income-tax has appealed to this
Court with special leave.
B
The assessee Company is a non-resident. It was incorporated
in the State of Delaware in the United States of America with the
object of taking over the assets of two companies-Socony Vacuum
Oil Company and Standard Oil Company (New Jersey). The capital of the assessee company was $10,000,000 divided into 100,000 C
shares of the value of $100 each.
On the date of acquisition the
book values of the assets of the two companies as recorded in their
books of account were :
Socony Vacuum Oil Company
Standard Oil Company
(New Jersey)
$97,715,701
. .. .
$46,767,397
In consideration of transfer of these assets, the assessee company
;
allotted to each company 49,995 shares and to Socony Vacuum
Oil Company serial bonds of the value of $13,093,000. The remaining ten shares were divided equally between the two transferor E
companies for cash at par value. The assessee company entered
in its books of account the book value of the assets taken over from
the transferor companies. The excess of the net value of the assets
so transferred over the par value of the stock issued and the serial
bonds was entered in the books in an account styled "Capital paid
in Surplus". The serial bonds issued to the Socony Vacuum Oil
F
Company were later redeemed. By adjustment entries the "Capital
paid in Surplus" account was reduced to $117,561,317 and
throughout the period of three years to which these appeals relate,
in the balance sheets of the assessee company, the "Capital paid in
Surplus" stood unchanged at that figure.
The net profits earned
by the Company year after year, subject to certain appropriations
G
were shown in the balance sheet under the caption "Earned Surplus" or "Earnings reinvested". At the end of 1945, the balance
of "Earned Surplus" was $29.557,597 and by the end of 1948
the account stood at $73, 766,592.
The Income-tax Officer disallowed the claim of the assessee
Company for inclusion of the accounts "Capital paid in Surplus"
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and "Earned Surplus" in the computation of taxable capital under
Sch. II r. 2(1) of the Business Profits Tax Act, and the Appellate
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C.I.T. V, STANDARD VACUUM (Shah, J.)
371
A Assistant Commissioner agreed with him. But the Income-tax
Appellate Tribunal held that the difference between the value of
the assets taken over and the value of stock and serial bonds issued
by the assessee Company was premium realized from the issne of
its shares and retained in the business within the meaning of r. 3 of
Sch. II and was in any event reserve not allowed in computing
B
profits within the meaning of r. 2(1). The Tribunal also held that
the amount entered in the account "Earned Surplus" was reserve
liable to be taken into account in assessing business profits tax.
In a reference under s. 19 of the Business Profits Tax Act, the High
Court agreed with the view of the Tribunal on the three questions
referred for its opinion.
c
The provisions of the Business Profits Tax Act, 194 7, which
have a bearing on the questions raised in the reference to the High
Court may first be summarised. By s. 4 of the Act in respect of
any business to which the Act applies, business profits tax is charged, levied and paid on the taxable profits during any accounting
D
period at the rates specified in the Act. The expression "Taxable
profits" is defined in s. 2(17) as the amount by which the profits
during a chargeable accounting period exceed the abatement in
respect of that period. "Abatement" is defined in s. 2(1) (insofar
as it is material) as meaning, in respect of any chargeable accounting period ending on or before the 31st day of March, 1947 a
E
sum which bears to a sum equal to (a) in the case of a company,
not being a company deemed for the purposes of s. 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 Sch. II, or one lakh of
rupees, whichever is greater, and (b) in respect of any chargeable
accounting period beginning after the 31st day of March, 1947,
F such sum as may be fixed by the annual Finance Act. Schedule II
prescribes rules for the computation "of the capital of a company
for purposes of business profits tax".
The material clauses are
2(1) and 3:
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"2. (1) Where the company is one to which rule 3 of
Schedult; 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, 1922 (XI of 1922), diminished by the
cost to it of its investments or other property the income
from which is not includible in the profits, so far as that
cost exceeds any debt for money borrowed by it.,
(2)
372
SUPREME COURT REPORTS
[1966] 2 S.C.R.
Explanation.-A reserve . or paid-up share capital
A
brought into existence by creating or increasing (by revaluation or otherwise) any book asset is not capital for
the purposes of ascertaining the abatement under this
· Act in respect of any chargeable accounting period.
3. So much of the preminm realised by a company
from the issue of any of its shares as it retained in
the business shall be regarded as forming part of its paidup capital for the purposes of rule 2."
B
The first two questions referred by the Tribunal relate to the
true nature of the amount entered in the books of account of the
C
assessee company under the caption "Capital paid in Surplus". lt
is a common practice in the United States of America in transactions in which business assets are transferred to a new company, to
issue shares of total par value less than the true value of the assets
transferred. Singer, who was Treasurer of Standard Vacuum Oil
Company and officiated as Treasurer and later as Vice-President of D
the assessee Company has stated in paragraph-5 of his affidavit
that, "The reason for limiting the stated or par value of the capital
stock of Standard Vacuum Oil Company to $10,000,000 rather
than including the entire capital of $131,391,098.71 in the par
value of issued stock was simply to reduce issuance taxes and fees
payable on the basis of the par value of stock issued, in view of the E
fact that the stock was held by only two corporate shareholders and
there was no need for a larger number of shares to be issued and
outsianding." In "Cases and Materials on Corporations" by Dodd
and Baker, 2nd Edn., at p. 1118 under the head "Sources of
Capital Surplus" the authors have stated :
"Credits to an account that is still generally called
Paid-in Surplus arise in a number of circumstances which
include : (a) where shares having a par value including
the very low par value that has recently come into use, are
issued and sold for cash or non-cash consideration in an
amount in excess of part
The
occasion for the issue may be an initial or subsequent
acquisition of property. Such a property acquisition may
be the purchase of all or substantially all assets of another
corporation as a going concern, or a merger by which
such another corporation is absorbed by the surviving
corporation, or a consolidation by which two or more
corporations are absorbed by a new corporation created
in the consolidation proceedings, Upon such a purchase
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C.I.T. V. STANDARD VACUUM (Shah, J.)
373
of assets or in a merger or consolidation, the defensible
value of the assets of the vendor or of the absorbed
corporation or corporations may not be "capitalized"
in its entirety, so that a paid-in surplus emerges from the
transaction."
In Fletcher's Cyclopedia Corporations Vol.
19
Paragraph
9237, the author has set out the prevailing method of carrying
into the balance sheet the amount of consideration received in
excess of par value under the head "Surplus" :
"
as dividends can be declared only out of
surplus earnings, and there must be an exact method
of determining whether surplus earnings for that purpose actually exist, it is the view of sound attorneys and
sound accountants that the only proper method of
handling,
in the accounts,
the item of no par value
stock is to set up on the books, as a charge against
capital, the amount of the consideration received for
each issue of such stock and that any other increases
or any decreases in net assets should be carried on the
balance sheet under the headings of Surplus and Deficit,
just as if the capital charge had been made in connection with the issuance of stocks having a par value.
They will therefore keep the capital stock entry a constant figure, representing the amount of consideration
received for the same, and, if the corporation earns
money, they will set up, on the liabilities side of the
balance sheet an item which they call "Surplus" or
"Undivided Profits."
. . . . . .
If additional no
par value stock is issued, although, under the theory
of no par value stock, it need not be issued at the same
price as the original issue but at such price as the directors determine to be for the best interests of the corporation, the number of shares issued will be added to the
number of shares outstanding and the consideration
received for the same will be added to the figures opposite the entry "Capital Stock," and thereafter the entry
of capital stock will continue to be a cons~ant item,
the adjustments for earnings or losses being made in
the accounts of "Surplus" or "Deficit" . . . . ."
H
It is also stated :
"In some of the States the legislature has introduced a complication by writing into the statutes which
374
SUPREME COURT REPORTS
[1966] 2 S.C.R.
provide for the issuance of no par value shares a proviA
sion "that, in setting up the no par value stock on the
books, a portion of the consideration received therefor
may be charged to "Stated Capital" and a portion to
"Paid-In Surplus".
Under the statutes of Michigan, the item of "PaidIn-Surplus" must be carried on the balance sheet as a
separate item from "Earned Surplus" or "Undivided
Profits," and such is the policy of many accountants
in the absence of any statutory provision."
Therefore stock is issued in consideration of transfer of assets,
the par value of stock is not necessarily equal to the value
1 of assets transferred.
Where the value of assets transferred
exceeds the par value, the difference may appropriately be regarded as "premium" according to the nomenclature used in India.
Under the Companies Act, 1913, shares could be issued for
cash or against transfer of property, and it is not claimed that
under the statute law in the State of Delaware a different rule
prevailed at the time when the assessee company took over the
assets of the transferor companies. The Indian Companies Act
also places no restriction upon a company issuing shares for a
consideration which exceeds the par value of the shares, and there
is no evidence on the record that in the State of Delaware there
·is such a restriction.
A share is not a sum of money : it represents an interest measured by a sum of money and made up
of diverse rights contained in the contract evidenced
by the
articles of association of the Company.
In the absence of any
restriction in the law of Delaware against
the issue of shares
otherwise than for cash, when shares are issued for consideration
other than cash the value of the assets transferred in excess of
the par value of shares issued would be regarded as premium
for purposes of our system of law. No serious argument has been
advanced before us on behalf of the Commissioner controverting
this part of the case.
When shares are issued to the public at a premium. ordinarily
premium at a uniform rat~ would be charged from all applicants
for shares.
But that is not because the law contains any prohibition against charging differential premiums.
The right of a
company to charge varying premiums in respect of blocks of
shares having the same rights issued under different resolutions
is not denied, and on principle there is no objection
to
the
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C.l.T. v. STANDARD VACUUM (Shah, /.)
375
A charging of varying rates of premium for shares issued under a
single resolution, if all the parties concerned agree. The amount
or value which a person intending to be a shareholder may pay
in excess of the par value for acquiring the shares of a company
depends upon the
contract between the company and such a
person.
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In the case under review, the two transferor companies were
willing to combine into a larger corporation, presumably to
avoid competition. The book value of the assets transferred by
Socony Vacuum Oil Company was undoubtedly larger than the
book value of assets transferred by the Standard Oil Company.
But for effectuating a combine, the two transferor companies in
a contract with the assessee company agreed to receive stocks
of equal par value carrying equal rights in consideration of transfer of assets of different values. If the excess paid by the transferor companies over the par value of the shares received may
be regarded as premium, and we hold that it does, it is not
necessary to enter into 'the correctness of the submission of the
assessee company that the difference in the value of the assets
transferred by the two companies was nominal,
because
the
Standard Oil Company had transferred
valuable
"intangible
assets" which had not entered into the book valuation of its
assets, and which bridged the difference between the value of the
assets transferred by that company and the assets transferred by
the Socony Vacuum Oil Company.
Under the Companies Act, 1913, shares of a class already
issued could be issued by a company at a discount, subject only
to the conditions prescribed by s. 105A.
But the Act made no
F
provision relating to the issue of shares at a premium.
The
matter was one go~erned by contract between the company and
the mtendmg acqmrer of shares.
In the Companies Act 1 of
195 6, certain restrictions are imposed upon the application of
premiums received on issue of shares by s. 78.
Shares could
therefore be issued at a premium under the Act of 1913 and that
app~ars to be recognised by the terms of s. 78 (3) of the ComG
H
panies Act of 1956.
It was found by the Tribunal that the amount entered in the
.bal~nce sheet as "Capital paid in Surplus" was retained in the
busmess of the assessee company, and the correctness of that view
was not challenged bef~re the High Court.
The only argument
advanced before the Htgh Court on this part of the case was
that shares could be said to be issued at a premium only when
376
SUPREME
COURT
REPORTS
[1966] 2 S.C.R.
they were issued for cash in excess of the par value and not
otherwise.
But shares may be issued subject to express statutory
provision to the contrary for money or services or in con~ideration
of transfer of property, and there is no reason to think that a
different rule applies when shares are issued at a premium. There
is no provision in the Companies Act of 1913, which enacts a
different rule, and it is not said that there is a statute in the
State of Delaware which enacts a different rule.
A_
B
Counsel for the Revenue maintained that the use of the expression "premium realised from the issue of any shares" in r. 3
of Sch. II implies that there must, prior to the allotment of shares
under which premium is charged, be some arrangement for payC
ment of consideration in excess of the par value of shares, and
in the absence of evidence to prove such an arrangement, the
capital surplus is not premium realised from the issue of shares.
No such contention was raised at any stage in these proceedings,
and a finding that there was before the shares were issued an
arrangement between the two transferor companies and the
D
assessee company that the shares were to be issued in consideration
of the transfer of assets of unequal book value held by the two
transferor companies is clearly implicit in the view expressed by
the Tribunal.
The High Court was therefore right in holding
that the difference between the book value of the assets transferred and- the par value of capital stock issued was premium.
E
The assessee company said that even if this amount of "capital
paid in Surplus" be not regarded as premium within the meaning
of r. 3, it is still "reserves" within the meaning of r. 2 (1). This
plea found favour with the High Court. Counsel for the Revenue
raised two contentions against acceptance of that view of the F
High Court : (1) that reserves contemplated by r. 2 (1) are only
those which are built out of profits processed for the purpose of
taxation under the Indian Income-truc Act; and (2) that where a
reserve is brought into existence by creating or increasing, by
revaluation or otherwise a book asset, it cannot be included in
the computation of capital by virtue of Explanation to r. 2.
In
G
support of his first contention Mr. Vishwanath Sastri relied upon
the' observations of Chagla, C.J. in Commissioner of Income-tax
v. Century Spg. & Mfg. Company £td. (1 )
Jn that case the
Bombay High Court held that profits of a company not allocated
to any specific head in the balance sheet at the end of the year
of account of a company may be treated as "reserves" for the
H
purpose of r. 2 of Sch. II of the Business Profits Tax Act, but
(l) 2•1 I.T.R. 260.
•
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C.I.T. V. STANDARD VACUUM (Shah, J.)
377
A the judgment of the Bombay High Court was reversed by this
Court : vide, Commissioner of Income-tax, Bombay City v. Cen·
tury Spg. & Mfg. Co. Ltd.( 1 ).
The profits of the company had
been subjected to tax, and the question whether an account which
is built up otherwise than out of profits of the business could be
regarded as reserves for the purpose of r. 2 did not faJI to be
B
decided in that case.
Under r. 2 (1) reserves which insofar as
they have not been allowed in computing the profits of the
Company enter into the computation of capital for the purpose
of r. 2 (1). This Court observed in Century Spinning & Manufacturing Company's case(') :
C
"Two essential characteristics must be present
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E
F
before the assessee can avail himself of the benefit of
the rule, namely, that the amount should not have been
allowed in computing the profits of the company for
the purposes of Income-tax Act and that it should be
a reserve as contemplated by the rule."
Rule 2 does not expressly say that the reserve admissible in
the computation of capital should be one built out of profits, and
this Court did not suggest that the rule contained such an implication. Observations made by Chagla, C.J. in Century Spinning &
Manufacturing Company's case(") at p. 264 :
"Therefore in order to determine the capital of the
company for the purposes of this Act you have got to
take the paid-up share capital of the company. then
you have to add to it the reserves and you have to add
only those reserves which have been subjected to
taxation",
and at p. 265 :
"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 dividends to the shareholders
but kept
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back by the Directors for any purpose to which it may
be put in future",
were only made in reference to the facts of the case and were
not intended to lay down that reserves built up from sources other
than profits will not be admissible for inclusion in capital under
r .. 2 ( 1) of the Business Profits Tax Act.
This contention is also
H
negatived by the terms of the Explanation. Reserves which may
be brought into existence by creating or increasing (by re-valuation
(I) [154] S.C.R. z,J3.
(2) 2) I.T.R. 260.
378
SUPREME COURT REPORTS
[1966] 2 S.C.R.
or otherwise) any book asset are expressly declared to be not
capital for the purpose of ascertaining the abatement. If reserves
which were built not out of profits were excluded from the operation of r. 2(1), it was hardly necessary to enact the Explana·
tion.
A
The Explanation to r. 2 has no relevance in the present case.
B
The difference between the assets received by the company and
the par value of the shares issued cannot be called a book asset
"brought into existence by creating or increasing (by re-valuation or otherwise)". The assets received by the assessee company
are real and tangible assets.
It is only for accountancy purposes
that a part of the value of the assets is allocated to the par value
C
of the shares and the balance to the "Capital Surplus brought in"
account. The High Court was therefore right in holding that the
account "Capital Surplus brought in" in the balance sheet repre·
sents premium realised from the issue of its shares within the
meaning of r. 3, or in the alternative represents reserves not
allowed in computing the profits of the company for the purpose D
of the Indian Income-tax Act, 1922.
The next question is whether "Earned Surplus" may be treated
as "reserves" within the meaning of sub-r. (I) of r. 2 of Sch. IT.
It is found by the Tribunal that the profits earned year after year
by the assessee company were retained and reinvested in its busiE
ness.
"Earned Surplus" has, it is true, not been called "reserve'',
but if it is truly a reserve, it must be taken into account in the
computation of capital.
In considering this question, it is necessary to note certain special features of the system of accounting
obtaining in the United States of America.
In the balance sheets
of companies the assets are balanced against liabilities,
capital
F
stock and surplus. In the company accounts it is usual to provide for specific or special reserves, but there is no allocation to
a head called "General reserve" in the accounts. It is also well
settled that the accounts of companies maintained under the
American system
are self-contained for each year.
Under the
system of accounting in vogue in India, after allocations are made
to various purposes such as. outgoings, expenses and reserves,
specific and general the 'balance is generally carried forward to
the next year. The amount so carried forward gets merged into
the account of the next year. If the capital and liabilities side
exceeds the property and assets side, the difference is carried forward as loss in the next year.
Under the American ~ystem of
accounting, whatever remains on hand at the end of the year is
entered on the liabilities, capital stock and surplus side as ".Earned
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C.I.T. V. STANDARD VACUUM (Shah, J.)
379
A Surplus".
This was pointed out in First National City Bank v.
B
c
D
E
Commissioner of Income-tax,
Bombay('), where Kapur,
J.,
speaking for the Court observed :
"There is a difference between the system of
accounting of banking companies in India and the
United States : . . . . In India at the end of a year
of account the unallocated profit or loss is carried forward to the account of the next year, and such unallocated ,amount gets merged in the account of that
year.
In the system of accounting in the U.S.A. each
year's account is self-contained and nothing is carried
forward.
If after allocating the profits to diverse heads
mentioned above any balance remains, 1t is carried to
the "Undividei Profits" which become
part of
the
capital fund.
If in any year as a result of the allocation there is a loss the accumulated Undivided Profit'
of the previous years arc drawn upon and if that fund is
exhausted the banking company draws upon the surplus. In its every nature the Undivided Profits
are
accumulation of amounts of residue on hand at the end
of year of successive periods of accounting and these
amounts are by the prevailing accounting practice and
the Treasury directions regarded as a part of the capital
fund of the banking company."
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 accounts of a banking company : they are applicable with
appropriate variations to accounts of all companies, and different
F
nomenclatures are used in the accounts to designate the residue
on hand as "Surplus'', "Undivided Profits", or "Earned Surplus".
G
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.
Such a fund may be regarded according to the
Indian practice as "general reserves".
The Appellate Tribunal held that the "Earned Surplus" in the
balance sheets of the assessee company represented "reserves"
I'
within the meaning of r. 2 Sch. II of the Business Profits Tax
H
Act.
The High Court agreed with that view.
But counsel for
the Revenue contended that accumulated profits could only be
(I) [1961] 3 S.C.R. 371.
380
SUPREME COURT
REPORTS
[1966] 2 S.C.R.
deemed reserves for the purpose of the Business Profits Tax Act,
A
if they are specifically allocated to reserves and not otherwise and
in support of that contention, he relied upon the decision of this
Court in the Century Spinning & Manufacturing Company Ltd.(')
Counsel pointed out that in that case this Court reversed the
decision of the High Court of Bombay in which accumulated
profits were regarded as reserves for the purpose of the Business
B
Profits Tax Act.
It is necessary carefully to scrutinise the facts
in the Century Spg. & Mfg. Company's case('). For the account
year ending December 31, 1945, the profit of the assessee company, amounted to Rs. 90,44,677 /-. After providing for depreciation and taxation there remained an unallocated balance of
Rs. 5,08,637 /- which was not allowed in computing· the profits
of the assessee for purpose of income-tax.
In February 1946,
the directors recommended that out of that amount a sum of
Rs. 4,92,426/- be distributed as dividend
and the balance of
c
Rs. 16,211/- be carried forward to the next year's account. The
recommendation was accepted by the shareholders and dividend
D
was shortly thereafter distributed.
In computing the capital of
the assessee company on April 1, 1946 under the Business Profits
Tax Act, 1947, the assessee claimed that Rs. 5,08,637/- carried
forward into the account of 1946 should be treated as "reserve"
for the purpose of r. 2(1) of Sch. IL This Court negatived the
contention.
Ghulam Hasan, J., speaking for the Court observed :
"On the 1st of January, 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 the 1st January, 1946, cannot automatically make it a reserve. On
the 1st April, 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
ear-mark it for distribution as dividend."
After referring to the judgment of the High Court, the learned
Judge observed :
(I) (1954] S.C.R. 203.
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F
G
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A
B
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C.I.T. V. STANDARD VACUUM (Shah, J.)
381
"The directors had no power to distribute the sum
as dividend.
They could only recommend, as indeed
they did, and it was upto 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 unutilized 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)."
It was pointed out that under the Indian Companies Act, 1913,
the directors are enjoined 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
o dividend and the amount, if any, which they propose to carry to
the reserve fund, general reserve or reserve account. It was also
pointed 1Jut that s. 132 of the Indian Companies Act refers to
the contents of the balance sheet to be drawn up in the Form
marked 'F' in Sch. III, and to Regulation 99 of the 1st Sch.
Table A, and observed that any sum out of the profits which is
E
to be carried into a reserve must be set aside before the directors
recommend any dividend.
The Court observed :
F
G
"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
o,f 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."
The Court was dealing in that case with the accounts of an
Indian Company,. the balance sheet of which was prepared according to the provisions of the Indian Companies Act, 1913. Regulation 99 of the 1st Sch. Table A, required that reserves must
be set apart before the directors recommended any dividend, but
out of the profits of the company no amount was set apart towards
H
reserv"s before the directors recommended payment of dividend
to the shareholders.
The identity of the amount remaining on
hand at the foot of the profit & loss account was not preserved.
I
382
SUPREME COURT REPORTS
[1966] 2S.C.R.
It is on these facts that the Court held that there was no allocation of the amount to reserve and from the mere fact that it was
carried forward in the account of the next year and ultimately
applied in payment of dividend, it could not be said to be specifically set apart for any purpose at the relevant date i.e., the end
of the year of account.
A
(
B
We are in this case dealing with a foreign company and the
system of accounting followed by the company is different in important respects from the system which obtains in India. Companies in India maintain diverse types of reserves : some may be
specific reserves, such as capital reserve, reserve for redemption
of debentures, reserve for replacement of plant and machinery,
C
reserve for buying new plant to be added to the existing ones,
reserve for bad and doubtful debts, reserve for payment of dividend, and general reserve.