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Petitioner: COMMISSIONER OF INCOME-TAX, KARACHI VS Respondent: MESSRS PAKISTAN SECURITY JUDGMENT
Court Name: Sindh High Court Judge(s): Ajmal Mian, Tanzil-ur-Rehman Title:COMMISSIONER OF INCOME-TAX, KARACHI vs MESSRS PAKISTAN SECURITY
JUDGMENT
Reported As: 1985 PTD 413 Result: Reference disposed of Judgment JUDGMENT ' AJMAL MlAN, J.-By this common judgment we intend to dispose of the above three Income-tax Reference filed under section 66 (1) of the Income-tax Act, 1922 (hereinafter referred to as the Act) pertaining to the, assessm ent years 1968-69, 1969-70 and 1970-71 (i. e. I. T. R. Nos. 324/1974, 291/1974 and 286 of 1974 respectively), which raised the following two common questions of law : '(1) Whether on the facts and in the circumstances of the case the Tribunal was justified in holding that while computing the 'free reserves' the reserves on account of gratuity were to be excluded although these were not mentioned in Notification No, S. R. O. 116 (R)/68, dated 1st July, 1968 issued by the Central Board of Revenue in pursuance of clause 2 (6-BB) of the Income-tax Act ? (2) Whether the list of reserves not qualifying as 'free reserves' given in Notification No, S. R. 0. 116 (R)/68, dated 1st July, 1968 was exhaustive ?" 2. The brief facts leading to the. Filing of the above references are that the respondents assessees in the year 1968-69 made a provision of Rs, 18,13,000 on account of gratuity payable to their employees. In the year 1969-70 the previous figure was increased to Rs, 19,60,000 and in the year 1970-71 this was further increased to Rs, 27,82,000. The Income-tax Officer while making assessm ent of the above three years separately disallowed the above amounts and treated the same as free reserves and levied the income-tax thereon. The respondents assessees filed appeals namely I. T. A. No, 7558/1971-72 for the assessment year 1968-69, I. T. A. No, 7559/1971-72 for the assessm ent year 1969-70 and I. T. A. No, 7560 of 1971-72 for the assessment year 1970-71 before the learned Income-tax Appellate Tribunal, Karachi Bench at Karachi. The above appeals were allowed by the learned Income-tax Appellate Tribunal by its order, dated 3rd April, 1973 and it was
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held that the above amounts were not free reserves but the reserves have been created to meet certain obligations being an ascertained liability. Reliance was placed by the Tribunal on its judgment given in Appeal No, 136-A of 1963-64 and some other appeals decided on 27th March, 1972. -The applicant department being aggrieved by the above judgment of the learned Income- tax Appellate Tribunal has filed the present three references. 3. In support of the above references Mr. Shaikh Haider, learned counsel for the applicant department has vehemently urged that since the reserve in question does not fall within the purview of the notification issued by the Central Board of Revenue in exercise of power conferred on it under section 2 (6-BB) of the Act, the learned Income-tax Tribunal committed error of law in holding that the above reserve was not in fact a free reserve. On the other hand Mr. Ali Athar learned counsel for the respondents assessees has contended that the assessees were entitled to make provision for their above ascertained liability in consonance with the proper principles of commercial accountancy and, therefore, the finding of the learned Income-tax Tribunal that factually the above provisions cannot be construed as free reserves is in accordance with law. 4. Before taking up the above contention of the learned counsel for the parties, it may be pertinent to observe that by Finance Act, 1968 subsection (6-BB) of section 2 was enacted defining the expression 'free reserve' and definition of 'income' given in subsection (6-C) of section 2 was also amended to make the free reserves subject to levy of income-tax. It may be advantageous to reproduce hereinbelow above subsection (6-BB), which reads as follows : "(6-BB) 'free reserves', in relation to a company, means such reserves of a Company as the Central Board of Revenue may, by notification in the official Gazette, declare to be free reserves of a company, and includes any unappropriated profits of a company ;" ' It may be noticed that under the above-quoted definition free reserves of a company are those which the Central Board of Revenue by notification under the official Gazette declare to be free reserves of a company and includes any unappropriated profits of a company. It seems that in pursuance of the above provision, the Central Board of Revenue issued S.R.O. 116 (R), dated 1st July, 1968 declaring all the reserves of a company other than the reserves mentioned therein, as free reserves. It may be pertinent to reproduce hereinbelow the above S.R.O., which reads as follows : "S. R. O. 116 (R)/68, dated 1st July, 1968. In exercise of the powers conferred by clause (6-BB) of section 2 of the Income-tax Act, 1922 (XI of 1922), the Central Board of Revenue is pleased to declare all the reserves of a company other than the following to be the free reserves of the company, namely :- (1) Reserves created as a result of revaluation of fixed assets. (ii) Goodwill Reserve. (iii) Depreciation Reserve to the extent of ordinary depreciation including allowance for extra shifts admissible under the aforesaid Act and Rules made thereunder. (iv) Development Allowance Reserve created under clause (via) of subsection (2) of section 10 of the aforesaid Act. (v) Workers Welfares Fund. (vi) Reserve for Taxation to the extent of the current liability of the company." ' It may be pointed out that the above-quoted Notification does not include gratuity as an item excluded from the purview of the definition of free reserves. However there is one item pertaining to the employees, namely, Workers Welfare Fund. ' On the basis of the above notification it was vehemently urged by Mr. Shaikh Haider that since the gratutity has not been excluded from the purview of the free reserves as defined in subsection (6- BB) of section 2 any reserve created on account of gratuity is subject to the levy of income-tax. Whereas it was vehemently urged by Mr. Ali Athar that the finding of the learned Income-tax Tribunal is that the above provision for gratuity is not a free reserve but it is provided with the
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object to meet the above-ascertained liability. It may be mentioned that the Income-tax Officer in his assessm ent order of the year 1968-69 had dealt with the above question in detail, whereas in the orders of the other two assessm ent years there is no discussion on this aspect. It may also be mentioned that the learned Income-tax Tribunal has not given detailed reasons in the aforesaid order, dated 3rd April, 1973 passed on the respondents' aforesaid three appeals on the question of the nature of the above provision for gratuity as it had followed its previous judgment dated 27th March, 1972 in the case of Karachi Gas Company Limited v. The Income-tax Officer, Central Circle I Karachi, inter alia in Appeal No, 136-A/63-64- CCI. It will be advantageous to reproduce hereinbelow the relevant observations of the Income-tax Officer in its aforesaid order for the assessm ent year 1968-69 and of the learned Income-tax Tribunal in the aforesaid judgment, dated 27th March, 1972, which read as follows : I.-T. Officer Order-"Capital Gains." Free Reserves :-Excess free reserves are shown at Rs, 32,48,176. The said amount does not include an amount of Rs, 18,13,000 representing the credit balance of the staff gratuity account. The exact nature of this account is that every year, a provision is made for the gratuity of the staff on the basis of the emoluments received by them and the amount is credited to this account. This is done on the accounting principle that the amount of gratuity is earned every year by the employees and thus it is debitable against the profits of the year in which it is earned, much though it is payable only when the employees retire from the service. Thus it would be seen that it is an internal financial arrangement of the assessee company and it does not change the legal position of the amount so reserved. Legally, the provision for gratuity represents nothing but profits set apart for meeting a future liability. Asked to explain the reason for not including the balance of this account in Free Reserves, the assessee's counsel stated as under :- "The provision is in the nature of staff welfare which has been excluded from the definition of free reserves in the Notification No, S.R.O. 116 (R) 68. The amounts have been arrived at on the basis of a detailed calculation of the liability actually accrued to individual members on the balance-sheet date, although the actual payment will be made as and when an employee leaves the company. This cannot, therefore, in any way be termed as reserves." ' The assessee's contention cannot be accepted for the following reasons :- (1) The nature of this account is different from Welfare Fund excluded from the definition of Free Reserves. (2)The funds credited to this account continue to be the property of the company. (3)The liability in respect of gratuity arises only when the employee retires or otherwise leaves the service. (4)Even for the purpose of computation of income under section 10 the assessee claims not the amount credited to this account but the actual payment made by way of gratuity from this account. In short, the credit balance of this account is nothing but profits set apart in reserve for eventually meeting the liability arising at the time of retirement or otherwise of the employees. There was, thus no specific liability against this Reserve at the end of the accounting year. The credit balance in this account, therefore, constitutes free reserve. Rs, Free Reserves shown 32,48,176. Add as discussed = 18,13,000 Rs, 50,61,176 above ' The assessee has furnished incorrect particulars of its income for which proceedings under section 28 are being separately initiated." Tribunal judgment dated 27-3-1972. "The next objection concerns the free reserves. The appellant showed a sum of Rs, 64,26,388 but the Income-tax Officer took the same at Rs, 1,57,83,313. In arriving at his results the Income-tax Officer included therein the provisions for gratuity benefits by treating them as a contingent liability and also took into consideration the excess of the depreciation which worked out at Rs, 2,40,51,867
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against the tax depreciation amounting to Rs, 1,51,10,287. So far as the first reserve is concerned the appellant's main argument is that the provision for gratuity may be inadmissible item so far as the calculation of profits under section 10 is concerned, but the method of calculating free reserves is completely different. It is argued that by S.R.O. 116-68, dated 1st June, 1968 the Central Board of Revenue defines the due reserves and in this definition such a provision for gratuity benefits does not figure. Moreover, in fact it is not a free reserve as this provision is tied down by its very nature and is meant to fulfil certain definite obligations. These obligations may be contingent or otherwise but the reserve having been created to meet certain obligation and being an ascertained liability cannot partake of the nature of free reserve. We agree with the appellant's contention that such a provision cannot constitute a free reserve by its nature a free reserve can be utilized in any manner. This provision even it is to be dealt as a reserve, is clearly tied down to a particular contingency or liability. In the case of the appellant it is calculated on definite basis and the obligation under it continues to accrue or arise notwithstanding the actual contingent in which it may have to be paid off. Thus we cannot subscribe to the Income-tax Officer's view that this is a free reserve." ' It may be pointed out that the respondents assessees' learned counsel had urged before the Income-tax Officer that the provision for the gratuity was in the nature of staff welfare fund and, therefore, was excluded from the definition of free reserve in the above-quoted notification. This contention was repelled by the Income-tax Officer for the reasons that the nature of this account was different from welfare fund, the fund created continued to be the property of the company, the liability in respect of gratuity would arise only when the employee would retire and that it was profits set apart in reserve for eventually meeting the liability arising at the retirement or otherwise of the employees. Whereas the learned Income-tax Tribunal held that the provision for gratuity was not a free reserve but tied down by its very nature and was meant to fulfil certain definite obligations for ascertained liability. 5. (a) Mr. Shaikh Haider in furtherance of his above submission has also contented that since the term free reserve has not been defined in the Act, reference has to be made to its ordinary literal meaning. To fortify his above submission he has referred to the definition of the term 'reserve' given in some of the books/dictionary referred to herein-below and has also cited the following cases on the question, whether a provision for gratuity can be subject to levy of income-tax. (i) A Dictionary of Economics and Commerce by J. L. Hanson Fifth Edition which defines the term "Reserves" at pages 397 and 398 as follows :- "Reverves.--Instead of distributing its entire profits to its shareholders a company will place some of its reserves. A firm may maintain separate reserve funds for different purposes, such as a general reserve, depreciation reserve, etc. Many firms help to finance their expansion from reserves built up for this purpose. (ii) Book Keeping and Accounts by Rup Ram Gupta and Vidya Saran Gupta 1981 Edition, p. 437 wherein the authors have referred to the definitions of provisions and reserves with reference to the Indian Companies Act, 1956 in the following terms : Provisions.-The term 'provision' means any amount retained in the business in order to provide (a) for any known reduction in the value of an asset, or (b) for any known liability., the amount of which cannot be ascertained with reasonable accuracy. ' The term 'provision' must not be used for amounts set aside to provide for prospective losses or liabilities. It must only be used to indicate known reduction in the value of an asset or to provide for known liabilities, the amount of which cannot be estimated with reasonable accuracy. If the amount of a known liability ca be ascertained correctly, it must be classified as a liability and no as a provision.
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' Examples of provisions are provision for depreciation, provision for bad debts, provision for taxation, provision for contingencies, etc. Provision for bad and doubtful debts.-In the Balance Sheet of a company, the amount of sundry debtors is to be shown after deduction of provision for doubtful debts. The provision for doubtful debts should not exceed the amount of debts considered doubtful or bad, and any surplus of such provision should be treated as a `Reserve for Doubtful Debts' and shown on the liabilities side under the heading 'Reserves and surplus'. This is an important point to remember. Reserves.-The term 'reserve' covers any sum which is not a provision or a liability, and therefore it describes amounts set aside out of profits to provide for prospective losses or liabilities thereby increasing the working capital of the company and strengthening its financial position. ' Reserves are placed in two categories, namely ; capital reserves and revenue reserves. Capital reserves.-A capital reserve includes amounts which are not fret for distribution in the form of cash dividends through the Profit and Loss Account. A capital reserve can be used for issuing bonus shares. ' Examples of capital reserves are share premium account, development rebate reserve and fixed assets revaluation reserve. Revenue Reserve.-A revenue reserve is any reserve which I not a capital reserve, and which is, therefore, available for distribution as dividend. ' Examples of Revenue reserves are general reserve, dividend equalisation reserve staff welfare reserve, debenture redemption reserve, investment depreciation reserve, etc." (iii) Commissioner of Income-tax, Madras v. Indian Metal and Metallurgical Corporation, 1964 PTD 194, in which the facts were that the respondent assessee who kept its accounts on the mercantile system, credited to a separate account called the gratuity reserve account' a sum of Rs, 5,600 being approximate fifteen days wages of all employees and workmen who were in its service during the year of account, with the object of maintaining a fund to meet its eventual liability under section 25-F of the Industrial Disputes Act, in case any of the employees or workmen had to be retrenched. This amount was claimed as business expenditure under section 10 (2)(xv) of the Income-tax Act, which was disallowed on the ground that it was only a prospective liability of a contingent nature. Upon reference before the High Court it was held that the credit of Rs, 5,600 being merely a provision by way of reserve by the assessee to meet the liability, if any, to which the asseSsee may become subject in the event of retrenchment. It was further held that it was not a liability in praesenti in the year of account but a liability which may arise de futuro on happening of a particular contingency and, therefore, could not be allowed as a deduction either under section 10(2)(xv) or on commercial principles as to computation of profits. It was also held that though in the mercantile system of accounting, a debit of an accrued liability would be a proper charge on the revenue receipts and it is not necessary that there should have been any actual disbursement in such system of accounting to enable the assessee to make the claim of deduction. It may be pointed out that in this case the liability of the assessee was contingent in the sense that he would have been liable to pay gratuity only in the event of his retrenching any workman in terms of section 25-F of the Indian Industrial Disputes Act. The provision was made for all the employees though the eventuality of retrenching them or any one of them might have not arisen. (iv) Gordon Woodroffe Leather Manufacturing Company V. Commissioner of Income-tax, Madras (1962) 44 I T R 551. In the above case the facts were that a person who was an employee of the managing agent of the assessee company from 1922 to 1935 and was an employee of the assessee from 1935 and also its Director from 1940, was paid gratuity of Rs, 40,000 by the assessee company in appreciation of his long and valuable services to the company. The company had no scheme for payment of gratuities nor it was a practice followed by the company. There was nothing on record to indicate that the employee in question had accepted the low salary in
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expectation of a gratuity on retirement. The question before the Indian Supreme Court was, whether the judgment of the Madras High Court that the above amount of Rs, 40,000 could not be claimed as a deduction within the meaning of section 10 (2) (xv) of the Act was proper. While dismissing the above appeal against the judgment of the High Court it was held by the Indian Supreme Court that the proper tests to apply in a case like this are whether the payment was made as a matter of practice which affected the quantum of salary or there was any expectation by the employee of getting a gratuity or the sum of money was paid on the ground of commercial expediency and in order indirectly to facilitate the carrying on of the business. It was further held that the above payments did not satisfy the above test and were rightly disallowed. (v) Lakhamichand Muchhal v. Commissioner of Income-tax, M. P. (1963) 48 I T R 562 in which the facts were that the assessee, a registered firm paid to its munim as gratuity on his retirement a sum of Rs, 21,000 and claimed the amount as a deduction. The question before the Division Bench of the Madhya Pradesh High Court was whether the above payment was deductible under section 10(2) (x v) of the Act. While answering the above question in the negative it was observed that there was no practice of the assessee firm to give gratuity to its employees and that the payment of gratuity to Munim was the first instance of its kind and that there was no evidence to show that the Munim expected to get gratuity when he entered the service of the firm on a salary of Rs, 150 per month and, therefore, the above payment could not be claimed as a deduction under the above provision of the Income-tax Act as revenue expenditure. (vi) The Indian Molasses Company (Private) Ltd. v. The Commissioner of Income-tax, West Bengal AIR 1959 SC 1049. In the above case the facts were that one Mr. Harvey was the Managing Director of the assessee Company in 1948. He had been serving the Company by then for 13 years and was due to retire at the age of 55 years on 20th September, 1955. There was an agreement by which the Company undertook to provide a pension to Harvey after his retirement. On 16th September, 1948 the Company executed a Trust Deed in favour of three Trustees to whom the Company paid a sum of 8,208-19-0 (Rs, 1,09,643) and further undertook to pay annually Rs, 4,364 ( 326-14 sh.) for six consecutive years, and-the trustees agreed to execute a declaration of trust. There was also provision for the management of the above fund by the trustees in the form of taking deferred annuity policy from the Norwich Union Life Insurance etc. Mr. Harvey died before he attained the age of 55 years. The assessee company paid the initial sum and the yearly piemia before Harvey died for the assessm ent years 1949-50, 1950-51, 1951-52 and 1952-53, it claimed a deduction of these sums from its profits or gains under section 10 (2) (xv) of the Act. Inter alia the question before the Indian Supreme Court was, whether the Calcutta High Court was right in answering the question namely, whether the income from the trust profits comes within the scope of section 4 (3) (1) and, therefore, was entitled to exemption, in the negative. The Supreme Court while allowing the appeal held that the income from the trust profits comes within the scope of above section 4 (3) (1) and therefore was subject to exemption. While deciding the above question inter alia, it was observed by the Supreme Court that if the pension itself be not payable as an obligation, and if there be a possibility that no such payment may be necessary in the future, the whole of the amount cannot be deducted but only the present value of the future liability, if it can be estimated. (vii) ' Commissioner of Income-tax v. Sri Ranilakshmi Ginning, Spinning and Weaving Mills (P.) Ltd. 1982 PTD 277 in which the facts were that there was a settlement between the assessee company and the labour union on 7th September, 1971 by which the assessee company agreed to introduce the gratuity scheme with effect from 1st January, 1969. It was agreed that the assessee would pay gratuity to its employees, who retired after December 31, 1968 and who had put in a minimum qualifying service mentioned therein. After that the assessee employed an actuary for determining the liability towards gratuity as on December 31, 1970 amounting to Rs, 1,20,338. The assessee n-,ade the necessary provision and claimed the amount as a deduction in the assessment year
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1971-72. The Income-tax Officer rejected this claim. He allowed only to the extent of the provision made in respect of the current year and holding that the gratuity on the basis of the actuarial valuation relating to past years would be allowed as deduction as and when the payments were to be made to the workers. The assessees appealed before the Assistant Appellate Commissioner who held that the entire liability was an admissible deduction under section 37 (1) of the Indian Income-tax Act, 1961, as the assessee had introduced the scheme with effect from 1st January, 1969. The department's appeal before the Income-tax Tribunal was dismissed. Upon reference before the Madras High Court a Division Bench maintained the order of the Tribunal and observed as follows "That the expenditure was incurred wholly and exclusively for the purposes of the assessee's business cannot be open to doubt. The assessee made the provision only to pay its employees when they retired. The assessee had also been forced to adopt the scheme by giving it retrospective operation from 1st January, 1969. The effect of the retrospective introduction of the scheme was to permit payment of gratuity even to persons who had retired on or after 1st January, 1969 and before the scheme was actually agreed with the labour on 7th September, 1971. The agreement with the labour was arrived at bona fide. In these circumstances, the only question that arises for consideration is whether by reason…
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