Judgment:
Ratnam, J.
1. In this tax reference case under section 256(1) of the Income-tax Act, 1961 (hereinafter referred to as 'the Act', read with section 18 of the Companies Profits Surtax Act, 1964 (hereinafter referred to as 'the Surtax Act'), at the instance of the Revenue, the following question of law has been referred to this court for its opinion :
'Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that the amount standing to the credit of the gratuity reserve account to the tune of Rs. 3,51,000 should not be treated as a provision, but should be treated as a 'reserve' and should, therefore, be taken into account while computing the capital of the assessee-company for surtax purposes ?'
2. For the year ending March 31, 1971, out of the profits for the year, the assessee transferred Rs. 2.51 lakhs to the gratuity reserve account. Likewise, from out of the profits for the year ending March 31, 1972, another sum of Rs. 1 lakh was transferred out of profits. The assessee did not have an approved gratuity scheme and the amounts referred to earlier were ad hoc transfers to the reserve fund. For the assessment year 1973-74, in making the surtax assessment on the assessee-company, the Income-tax Officer omitted to take into account the gratuity reserve of Rs. 3.51 lakhs for capital computation on the ground that it was in the nature of a mere provision, though camouflaged as a reserve. Aggrieved by this, the assessee-company preferred an appeal and the Appellate Assistant Commissioner also took the view that the amount of Rs. 3.51 lakhs in the gratuity reserve account was only a provision and not a reserve and dismissed the appeal, upholding the action of the Income-tax Officer, in treating the aforesaid amount as a provision. However, on further appeal by the assessee-company before the Tribunal, it was inclined to view the setting apart of the profits by the assessee-company from year to year with no approved gratuity scheme, as such, as one anticipated by the assessee, or, compelled to be provided for by the assessee under the provisions of the Payment of Gratuity Act, which came into force on September 16, 1972, and, therefore, it was open to the assessee to make payment of gratuity out of current funds of the business and the amounts transferred for that purpose cannot be treated as a provision and even if the setting apart of the amount cannot be regarded as constituting part of the general reserve, that would be in the nature of a particular reserve includible for purposes of capital computation for surtax assessment. That is how the above referred question of law has been referred to this court.
3. Though, earlier, there had been some difficulty experienced in ascertaining whether sums so set part really constituted provisions or reserve, particularly from the point of view of computation of capital for purposes of surtax assessment, that has since been set at rest by the decision of the Supreme Court in Vazir Sultan Tobacco Co., Ltd. v. CIT : [1981]132ITR559(SC) . In that case, the Supreme Court considered whether, among others, amounts retained or appropriated or set apart by the assessee-company by way of making provision for retirement gratuity in a sum of Rs. 9,08,106 could be considered as other reserve within the meaning of rule 1 of the Second Schedule to the Super Profits Tax Act, 1963, or rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964, for inclusion in the capital computation of the company for purposes of levying super profits tax. In that case, a sum of Rs. 9,08,106 was an ad hoc appropriation or transfer to gratuity reserve, not based on any actuarial valuation, and, as here, there was also no approved scheme. In those circumstances, the Supreme Court succinctly summarised the law relating to this which can be set out in the following propositions. There is a well-marked distinction and difference between a 'reserve' and a 'provision', which is well known in commercial accountancy. (1) A 'reserve' is an appropriation of profits and not a charge against profits and as a reserve is created by appropriation out of profits of a business to meet contingencies unknown and which cannot be foretold, it does not go out of the business but is retained to form part of the capital employed in the business. A 'provision' is a charge against profits, to be taken into account against gross receipts in the profit and loss account and is intended to meet liabilities which are known and foreseeable, but whose timing and quantification remain uncertain at that moment. (2) The liability to pay gratuity to employees, though a definite one, when exactly it becomes payable, is dependent upon several contingencies. That, however, does not make it difficult or impossible to provide, here and now, for the liability with a view to meet easily the situation as and when it arises and when such a provision is made, it is a definite liability if it is done on scientific principles, in which case the provision will be a charge against the profits of the year in which the provision is made, and it would be a 'provision' and not a 'reserve'. (3) To provide for gratuity liability, an employer may adopt any one of the following three courses : (i) He may set apart an ad hoc sum as a 'provision' for gratuity; (ii) he may avail of the services of an actuary and arrive at an actuarial valuation of the estimated liability, i.e., a fairly accurate appraisal of the present cost of future commitment for gratuity and make a provision for such a liability for such an amount. (iii) The employer may obtain actuarial determination of the liability, but while making an appropriation of the profits and retention thereof, he may make a provision in excess of the actuarial determination.
4. In the first of the cases referred to above, the ad hoc amount provided by the employer, although not on actuarial basis, is only in the nature of 'provision' and a charge against profits and the ad hoc nature of the provision cannot render it a 'reserve', for, it is still in the nature of a 'provision' for liability, certain and foreseen, except that it is an ad hoc provision. In the second, the liability is foreseen and also accurately ascertained on an actuarial calculation and the amount set apart is an exact amount to meet a current liability and thus a 'provision'. In the last of the cases, the amount set apart comprises the liability determined on an actuarial valuation plus an amount over and above the actuarial figure and, to the extent it represents the amount arrived at on an actuarial valuation, it is a 'provision' and has to be dealt with as a charge against the current profits, but to the extent to which 'provision' is made over and above the actuarial valuation, that, which has been so retained cannot be regarded as a 'provision', for, whatever be the name, the excess created is really a 'reserve', because it is over and above what has been determined as a proper charge against current profits.
5. The above propositions have been laid down by the Supreme Court on the basis of the basis principles of corporate accounting as well as the provisions of the Companies Act, but at the same time, the Supreme Court cautioned that it would be necessary to go into the nature and character of the appropriation, the intention and purpose and other surrounding circumstances to decide whether it is a 'reserve' in the sense that it is retained as part of the company's capital.
6. Applying the tests laid down by the Supreme Court referred to above, what is found is that there had been ad hoc transfers by the assessee to the gratuity reserve fund, and, in such a case, the Supreme Court has clearly pointed out at page 574, that if an ad hoc sum is appropriated without resorting to any scientific basis, such appropriation would also be a provision intended to meet a known liability. From the facts available in the statement of the case, and in the light of the principles laid down by the Supreme Court in the decision referred to earlier, the Tribunal was in error in concluding that the amounts transferred by the assessee should be regarded as part of the general reserve or at least in the nature of a particular reserve for purposes of capital computation for surtax assessment, we, therefore, answer the question referred to us in the negative and in favour of the Revenue. There will be, however, no order as to costs.