1505. Whether credit balance in profit and loss account can be treated as reserve for computing capital of company
Circular No. 458 was issued by the Central Board of Direct Taxes on 16 June 1986. Its subject is 1505. Whether credit balance in profit and loss account can be treated as reserve for computing capital of company.
Explains when a credit balance in the profit and loss account counts as a reserve for computing a company's capital. The circular takes the Supreme Court's decision in CIT v. Century Spg. & Mfg. Co. Ltd. [1953] 24 ITR 499, given on rule 2(1) of the Schedule to the Business Profits Tax Act, where a credit balance of over Rs. 5 lakhs standing on 1 April 1946 was held not to be a reserve because on that date nobody with the requisite authority had indicated the manner of its disposal or its destination; it remained a mass of undistributed profits available for distribution and not earmarked, and a reserve, whether general or specific, needs a clear indication that it is one. That reasoning, the circular says, applies equally to the meaning of 'reserve' in the Second Schedule to the Super Profits Tax Act, 1963. It adds the accounting sense: a reserve is an appropriation out of past profits and surpluses that is not designed to meet any liability, contingency, commitment or known diminution in the value of assets as at the balance-sheet date, created for such objects as financial stability, equalising dividends, future expansion, replacing assets at higher prices, avoiding excessive dividends in good years, meeting losses peculiar to the business, reducing debentures or redeemable preference shares, or saving for future taxation.
The question whether an unappropriated credit balance in the profit and loss account could be treated as a reserve for capital computation had to be settled for the officers working these assessments.
1505. Whether credit balance in profit and loss account can be treated as reserve for computing capital of company
This question [as to whether the credit balance in the profit and loss account can be treated as a reserve] was considered by the Supreme Court in CIT v. Century Spg. & Mfg. Co. Ltd. [1953] 24 ITR 499 in the context of rule 2(1) of the Schedule to the Business Profits Tax Act under which the reserves were treated as forming part of the capital of a company, as under the Super Profits Tax Act. In that case the company held a credit balance of over Rs. 5 lakhs in its profit and loss account as on April 1, 1946. The question for decision was whether in computing the capital of the company as on April 1, 1946 (which was the first day of the chargeable accounting period for Business Profits Tax) the said credit balance in the profit and loss account could be treated as a reserve. The Supreme Court held that the amount could not be treated as a reserve. It observed :
"On April 1, 1946, which is the crucial date, the sum .... could not be called a ‘reserve’ for no body possessed of the requisite authority had indicated on that date the manner of its disposal or destination. It remained on April 1, as a mass of undistributed profits which were available for distribution and not earmarked as ‘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.....cannot automatically make it a reserve.....Thus, the profit lying unutilised and not specially set apart for any purpose on the crucial date did not constitute reserve......"
This decision is also applicable to the interpretation of the meaning of the term "reserve" with reference to the provisions of the Second Schedule to the Super Profits Tax Act, 1963.
In this connection, it may be mentioned that in accordance with the principles of accountancy, reserve consists of appropriation from profits and other surpluses which have been earned in the past, being amounts which are not designed to meet any liability, contingency, commitment or diminution in the value of assets known to exist as at the date of the balance-sheet. The general objects of creating a reserve are to make a provision for promoting financial stability, equalising dividends, providing for future expansions and for replacements of assets at increased prices, avoiding declaration of excessively high dividends in years of prosperity, meeting possible losses peculiar to the character of the company’s operations, reducing loans (debentures) or redeemable preference shares or setting aside savings for future taxation.
Circular : No. 1-D(SPT) of 1963 (relevant extracts), dated 28-10-1963.
In an old surtax or super profits tax capital computation where an unappropriated profit and loss balance was claimed as part of capital.
Rules it names. Rule 2 of the Income-tax Rules, 1962. The 1962 Rules were replaced by the Income-tax Rules, 2026, which renumbered nearly everything: a rule number quoted here almost never means the same rule today.
Source: the Income Tax Department’s own published text — its page for this instrument.