These are references by the Income Tax Appellate Tribunal to this Court under Section 257 of the Income Tax Act, 1961. The references have been made because of a divergence of opinion between several High Courts.
The Assessment Year in question in Tax Reference Case No.13 of 1981 is 1973-74; in Tax 1973-74; and in Tax Reference Case No.16 of 1981 it is 1972-73.
The assessee in the three cases is the same. It is a company engaged in the business of generation of electricity and distribution thereof to consumers. It is governed by the Electricity (Supply) Act, 1948.
For the sake of convenience the facts in Tax Reference Case No.13 of 1981 are set out. By reason of the provisions of the Electricity (Supply) Act and of the Sixth Schedule thereto, the assessee appropriated the sum of Rs.46,460/out of its revenues to a Contingency Reserve account during the previous year relevant to the Assessment Year 1973-74. This amount was claimed by the assessee as a deduction in the computation of its total income for the purposes of income tax. The I.T.O. rejected the claim. The Appellate Assistant Commissioner allowed the assessee’s appeal, relying upon the decision of the Kerala High Court in the case of Cochin State Power & Light Corporation Ltd. vs. C.I.T., Bombay, 97 I.T.R.334. The Revenue filed an appeal before the Tribunal and cited the judgment of the Madras High Court in the case of Vellore Electric Corporation Ltd. vs. C.I.T..Madras, 109 I.T.R. 454. The Tribunal relied on the decision of the Madras High Court, which had disagreed with the view taken by the Kerala High Court and the Bombay High Court. It set aside the order of the Appellate Assistant Commissioner, but referred the following question to this Court :
"Whether, on the facts and in the
circumstances of the case, the Income-
tax Appellate Tribunal was correct in
holding that the sum of Rs.46.460
transferred to the Contingencies Reserve
Account is not allowable as a deduction
in arriving at the taxable business
income of the assessee-company?" Section 57 of the Electricity (Supply) Act reads thus :
"57. Licensee’s charges to consumers -
The provisions of the Sixth Schedule
shall be deemed to be incorporated in
the licence of every licensee, not being
a local authority -
(a) in the case of a licence granted
before the commencement of this Act,
from the date of the commencement of the
licensee’s next succeeding year of
account; and
(b) in the case of a licence granted
after the commencement of this Act, from
the date of commencement of supply,
and as from the said date, the licensee
shall comply with the provisions of the
said Schedule accordingly, and any
provisions of the Indian Electricity
Act, 1910 (9 of 1910), and the license
granted to him thereunder and of any
other law, agreement or instrument
applicable to the licensee shall, in
relation to the licensee, be void and of
no effect in so far as they are
inconsistent with the provisions of
Section 57-A and the said Schedule." The Sixth Schedule to the Electricity (Supply) Act sets out financial principles applicable to electricity companies and their application. Clause I requires a licensee to so adjust his charges for the sale of electricity that his clear profit in any year of account shall not, as far as possible, exceed the amount of reasonable return. The expressions "clear profit" and "reasonable return" are defined in the Sixth Schedule. Sub-clauses (1) and (4) of clause II reads thus :
"II.(1) If the clear profit of a
licensee in any year of account is in
excess of the amount of reasonable
return, one-third of such excess, not
exceeding five per cent of the amount of
reasonable return, shall be at the
disposal of the undertaking. Of the
balance of the excess, one-half shall be
appropriated to a reserve which shall be
called to Tariffs and Dividends Control
Reserve and the remaining half shall
either be distributed in the form of a
proportional rebate on the amounts
collected from the sale of electricity
and meter rentals or carried forward in
the accounts of the licensee for
distribution to the consumers in future,
in such manner as the State Government
may direct.
"(4) On the purchase of the undertaking,
after the expiry, or on the revocation,
of its licence or otherwise, all amounts
of rebate lying undistributed to the
consumers on the date of such purchase
shall be handed over to the purchaser
who, in turn, shall enter the same in
the his books of account, under the
heading Consumers’ Rebate Reserve and
any amount lying undistributed in that
Reserve shall be carried forward for
distribution to the consumer concerned :
Provided that the share of money in the
Consumers’ Rebate Reserve payable to the
consumers who are not traceable or who
have ceased to be consumes in relation
that undertaking, may be utilised in the
development works of the purchaser." Clauses III, IV & V are most relevant to our purpose and they read thus :
"III. There shall be created from
existing reserves or from the revenues
of the undertaking a reserve to be
called "Contingencies Reserve".
IV. (1) The licensee shall appropriate
to Contingencies Reserve from the
revenues of each year of account a sum
not less than one-quarter of one per
centum and not more than one-half of one
per centum of the original cost of fixed
assets, provided that if the said
reserve exceeds, or would by such
appropriation be caused to exceed five
per centum of the original cost of fixed
assets, no appropriation shall be made
which would have the effect of
increasing the reserve beyond the said
maximum.
(2) The sums appropriated to the
Contingencies Reserve shall be invested
in securities authorised under the
Indian Trusts Act, 1882, (2 of 1882),
and such investment shall be made within
a period of six months of the close of
year of account in which such
appropriation is made.
V. (1) The Contingencies Reserve shall
not be drawn upon during the currency of
the licence except to meet such charges
as the State Government may approve as
being -
(a) expenses or loss of profits arising
out of accidents, strikes or
circumstances which the management could
not have prevented;
(b) expenses on replacement or renewal
of plant or works other than expenses
requisite for normal maintenance or
renewal;
(c) compensation payable under any law
for the time being in force and for
which no other provision is made.
(2) On the purchase of the undertaking,
the Contingencies Reserve, after
deduction of the amounts drawn under
sub-paragraph (1), shall be handed over
to the purchaser and maintained as such
Contingencies Reserve :
Provided that where the undertaking is
purchased by the Board or the State
Government, the amount of the Reserve
computed as above shall, after further
deduction of the amount of compensation,
if any, payable to the employees of the
outgoing licensee under any law for the
time being in force, be handed over to
the Board or the State Government, as
the case may be. Before we advert to the judgments of the High Courts that took divergent views, it is appropriate to refer to the judgment of this Court in Poona Electric Supply Co. Ltd. vs. C.I.T.. Bombay City, 57 I.T.R.521. This was a case that related to the Consumers’ Rebate Reserve. The Poona Electric Supply Co. Ltd., the assessee in that case, claimed deduction of the amount credited to this reserve from its taxable income. This Court noted the provisions of the Electricity (Supply) Act and its Sixth Schedule and observed that their object was to statutorily rationalize and regulate the rates chargeable for energy supplied in the interest of the public and for electrical development. Under the rules emobodied in the Sixth Schedule certain appropriations and deductions had to be made to arrive at the clear profit; otherwise, the its might be manipulated to sustain a demand for abnormal rates. These rules had no concern with income-tax; though, for the purposes of arriving at the clear profit, the taxes paid were deductible. The Court then said :
"Under section 10(1) of the Income-tax
Act, tax shall be payable by an assessee
under the head "profits and gains of
business" in respect of profits and
gains of any business carried on by him.
The said profits and qains are not
profits regulated by any statute, but
profits in a business computed on
business principles. They are business
profits and not statutory profits. They
are real profits and not notional
profits. The real profit of a
businessman under section 10(1) of the
Income-tax Act cannot obviously include
the amounts returned by him by way of
rebate to the consumers under statutory
compulsion. It is as if he received only
from the consumers the original amount
minus the amount he returned to them. In
substance there cannot be any difference
between a businessman collecting from
his constituents a sum of Rs. Y in
addition to Rs. X by mistake and
returning Rs.Y to them and another
businessman collecting Rs. X alone. The
amount returned is not a part of the
profits at all."
(Emphasis supplied) After considering various judgments, this Court was led to observe that income tax was a tax on real income, i.e., the profit arrived at on commercial principles subject to the provisions of the Income-tax Act. The real profit could be ascertained only by making the permissible deductions. There was a clear-cut distinction between deductions made for ascertaining the profits and distributions made out of profits. In a given case, whether the outgoing fell in one or the other of the heads was a question of fact to be found on the relevant circumstances, having regard to business principles. Another distinction that had to be borne in mind was that between real profits and statutory profits, that is, between commercial profits and statutory profits; the latter were statutorily fixed for a specified purpose. The assessee was a commercial undertaking. It did the business of supply of electricity subject to the provisions of the Electricity (Supply) Act. As a business concern its real profit had to be ascertained on the principles of commercial accountancy. As a licensee governed by the statute its clear profit was ascertained in terms of the statute and its Schedule. The two profits were for different purposes - one was for commercial and tax purposes and the other was for statutory purposes in order to maintain a reasonable level of rates. For the purposes of the Electricity (Supply) Act, during the accounting year the assessee credited an amount to the Consumers Rebate Reserve. It was a part of the excess amount paid to it and it was reserved to be returned to the consumers. It did not form a part of the assessee’s real profit. So, to arrive at the taxable income of the assessee from the business, that amount had to be deducted from its total income.
In Cochin State Power & Light Corporation Ltd. vs. C.I.T.. Kerala, 93 I.T.R. 582, the question referred to the Kerala High Court was whether the Tribunal was right in holding that the sums transferred to the Contingencies Reserve, the Development Reserve and the Special Reserve were not to be deducted in arriving at the taxable income of the assessee, which was a company carrying on the business of distribution and supply of electricity and was governed by the provisions of the Electricity (Supply) Act, 1948. The High Court considered the nature of the Contingencies Reserve and observed :
"Paragraph III of the Sixth Schedule
indicates that the creation of the
contingencies reserve is from out of the
revenues of the undertaking. This is
quite significant. The term "revenue" in
the context in which it has been used in
that Paragraph refers to the total
receipts and not to what is left as
profit after meeting the expenses.
Therefore, the creation of a reserve is
irrespective of the profit of the
licensee. It is either out of the
existing reserves or from the revenues
of the undertaking. As Paragraph IV of
the Sixth Schedule indicates, the amount
that has to be appropriated to such
reserve has no relation to the profit
made in any year, but is a fixed
percentage of the original cost of fixed
assets. The paragraph further provides
that on no account shall such
appropriation be made to such reserve to
exceed five per cent, of the original
cost of fixed assets. Sub-clause (2) of
Paragraph IV is also significant. The
sums appropriated to the contingencies
reserve have to be invested in
securities within a fixed period and it
is that which could be drawn upon for
specified purposes as provided under
Paragraph V(1). Sub-clause (2) of
Paragraph V indicates that on the
purchase of the undertaking this reserve
has to be handed over to the purchaser
and maintained as such subject to the
proviso therein. The High Court referred to this Court’s judgment in the case of Poona Electric Supply Co. Ltd. and the passage therein which is extracted above. It said that the view expressed by this Court appeared to it to be that in computing the commercial or real profit such diversions as the Consumers’ Benefit Reserve must be deducted. Though, before the Kerala High Court, counsel for the assessee urged that the amount of this reserve was not a part of the assessee’s income, what he really meant, the High Court said, as elaborated in the argument, was that in determining the real profits the statutory diversion in regard to these amounts had to be noticed and deducted. The Contingencies Reserve had been created from out of revenues and not out of profits and it was to be done irrespective of whether the assessee made a profit or not. Though the amount of the reserve could be utilised for certain purposes, the nature of the purposes indicated in clause V of the Sixth Schedule was sufficient to show that the purposes were not general. The Contingencies Reserve could be utilised only in certain specified contingencies. The amount of the reserve had to be invested in securities authorised under the Indian Trusts Act, 1882, and that had to be done within a specified time. Clause V provided that the Contingencies Reserve should not be drawn upon during the currency of the licence. This was subject to the exception that it could be drawn upon for meeting the charges therein specified as the State Government might approve. On the purchase of the undertaking the reserve had to be handed over to the purchaser, who had to maintain it as such. If the undertaking was purchased by the Electricity Board or the State Government, after deduction of the compensation payable to the employees of the out-going licensee, the reserve had to be handed over to the Electricity Board or the State Government. In the provisions in the Indian Electricity Act, 1910, relating to price fixation, when such Board or the State Government took over, no allowance was made in the purchase price for the amount of the Contingencies Reserve. All these provisions indicated that though to a very limited extent the assessee might have a benefit from out of the Contingencies Reserve, in that in certain contingencies which the State Government approved he might get the benefit of the amount reserved, generally, the amount was not one which was at the disposal of the assessee in the matter of its application. The creation of the reserve was apparently with the prime object of making available sufficient resources for meeting commitments necessary for the efficient running of the business, commitments which, if the licensee failed to meet them, would really affect the consumers. An uninterrupted supply of electric energy and proper maintenance of the supply from time to time by the licensee were amenities which had to be assured to the public and the object of the clause concerning this reserve appeared to be to assure them these. The High Court then said :
"Bearing in mind the fact that the
amount under the contingencies reserve
is not available to the assessee for any
purpose of him own or even for any
purpose other than those indicated in
Paragraph V of the Sixth Schedule and
also noticing the object of the creation
of this reserve and further noting the
provision that it is a diversion from
the revenue, we think that the diversion
is one which is deductible in
determining the real profit. There is
the further fact that the assessee does
not get even compensation on account of
this reserve as and when the undertaking
is purchased and even the purchaser has
to maintain the reserve as such.
Therefore, in spite of the distinction
that we have pointed out in regard to
certain features between this reserve
and the consumers’ benefit reserve with
which the Supreme Court was concerned in
the Poona Electric Supply Company by the
contingencies reserve is a diversion by
reason of overriding obligation created
by the statute and, therefore, for
determining the commercial profits of
the assessee, the amount of this reserve
has to be deducted." The question that was referred was, insofar as it related to the deduction of the amount credited to the Contingencies Reserve, answered in favour of the assessee.
The Bombay High Court followed the judgment in Cochin State Power & Light Corporation Ltd., in a Tax Reference. It said :
"In other words, it is clear that the
Kerala High Court was considerably
influenced, and in our view rightly, by
three or four aspects of this
contingencies reserve, namely, the
source from which this reserve is
created, the purpose for which this
reserve could be drawn upon as mentioned
in paragraph V, that this reserve was
not available to the assessee for any
purposes of its own, that the assessee
would not get any compensation on
account of this reserve as and when the
under taking would be purchased and that
the purchaser is required to maintain
the reserve as such. We, therefore, feel
that substantial reasons have been given
by the Kerala High Court for coming to
the conclusion that the transfers or
appropriations made by the assessee to
the contingencies reserve should be
deducted while computing the real profit
of the assessee. In this view of the
matter, the question, so far as it
relates to transfers or appropriations
made by the assessees to the
contingencies reserve in the instant
case before us, will have to be answered
in favour of the assessees. We
accordingly answer the question in
favour of the assessees. It is interesting to note that the same Bench of the Bombay High Court had thereafter occasion to consider the Contingencies Reserve in the context of the Wealth Tax Act, that is to say, whether the amount standing to the credit of that reserve was liable to be included in determining the net wealth of the assessee, which was also accompany that generated and supplied electrical energy and was governed by the provisions of the Electricity (Supply) Act, 1948. This was the case of Commissioner of Wealth Tax, Bombay vs. Bombay. Suburban Electric Supply Co. Ltd. The judgments in Cochin State Power & Light Corporation Ltd. and Amalgamated Electricity Co. Ltd. were cited on behalf of the assessee. It was submitted that in both these cases it had been held that the amount standing to the credit of the Contingencies Reserve was deductible under the Income-tax Act and, therefore, it could not be regarded as an asset. The Court said :
"At the outset it should be pointed out
that in both these cases the court was
really concerned with the question of
determination of the income of the
assessee-company under the head of
profits and gains of business. Questions
which may be relevant for the purpose of
determining the liability to pay income-
tax may not be germane or applicable
while deciding a question whether a
particular asset is an asset belonging
to the assessee and can be subjected to
a liability for payment of wealth-tax.
Under the Income-tax Act "income-tax" is
a tax on the real income, i.e., profits
arrived at on commercial principles
subject to the provisions of the Act.
The real profit can be ascertained only
by permissible deductions. We are not
concerned in the present case with the
question of determination of real
profits or real income. As shown in
paragraph III of Schedule 6,
contingencies reserve can be created
either from the existing reserves or
from the revenues of the undertaking
which by itself shows that it is created
from assets which form part of the net
wealth of the assessee-company. In can
never be said that existing reserves do
not form part of the assets of a
company. Even in the case of revenue it
is first received by the assessee and
thereafter it is appropriated in the
manner permitted by paragraph IV of
Schedule 6 of the Electricity (Supply)
Act. In either event it will be treated
as part of the assets belonging to the
assessee. The character of the asset is
not altered by the fact that there are
restrictions upon the user of the
contingencies reserve and that in the
event of a compulsory purchase under law
it has to be handed over to the
purchaser like the Electricity Board,
the State Government or local authority
who are under an obligation to maintain
such reserve and continue the
undertaking." The Madras High Court in Vellore Electric Corporation Ltd. vs. C.I.T. Madras, 109 I.T.R. 454, was required on a reference by the Tribunal to determine whether the Tribunal had been right in holding that the amount transferred to the Contingencies Reserve was not to be deducted in arriving at the taxable profits of the assessee, which was a company engaged in the business of generating and supplying electrical energy and was governed by the provisions of the Electricity (supply) Act, 1948. The decision of this Court in Poona Electric Supply Co. Ltd. was cited on behalf of the assessee. The Madras High Court said that it was of no assistance to the assessee. The amount standing to the credit of the Contingencies Reserve could not be said to be an amount which had gone out of the hands or control of the assessee and become the subject matter of ownership of somebody else. The statute had imposed certain restrictions over the disposal of that amount by the assessee, but that did not mean that the amount had ceased to be money belonging to the assessee. What was meant by diversion of profits by overriding title was that a part of profits earned by an assessee was not really his profit but it belonged to somebody else and the assessee had no title. As far as the Contingencies Reserve was concerned, the statute had clearly indicated the purposes for which it could be spent and those purposes clearly showed that they were connected with the business of the assessee and it was the assessee which would have to utilise it. Equally, the fact that the assessee was required to invest the amount standing to the credit of Contingencies Reserve in securities authorised under the Indian Trusts Act, 1882, did not in any way affect this position. The assessee continued to be the owner of the investment and, however limited be the benefit that the assessee might derive from such an investment, it could not be held that the investment was not the assessee’s investment but somebody else’s investment. Simply because the statute required a licensee like the assessee to make an appropriation out of its revenue for a particular purpose, and it was a compulsory appropriation which the assessee had to make, did not mean that for the purpose of income-tax such appropriation must necessarily be deducted for arriving at the profits and gains of the assessee’s business. The judgments in the case of Cochin State Power and Light Corporation Ltd., was, therefore, not followed.
The Calcutta High Court in Commissioner of Income Tax, West Bengal vs. Sijua (Jharriah) Electric Supply Co. Ltd., 145 I.T.R. 740, was also concerned with a case in which the assessee was an electric supply company governed by the Electricity (Supply) Act, which had appropriated an amount towards the Contingencies Reserve and had claimed its deduction in the computation of its business income. The cases aforementioned were considered. The Calcutta High Court held that there had been no diversion of income by an overriding title. The amount appropriated to the Contingencies Reserve was collected by the assessee as its revenue from sale of electricity. The amount remained at the disposal of the assessee and for the benefit of the assessee. It could be used only for a few specified purposes, but the purposes for which the fund could be used were all business purposes of the assessee. Payment of compensation to workers, replacement of plant and machinery and other expenditure envisaged in clause V of Schedule 6 were all normal business expenditure of a company. This was not a case of diversion of income before it reached the assessee but only a case of setting apart of a portion of the assessee’s income under compulsion of law for the use and benefit of the assessee although the mode and the objects of the expenditure were statutorily restricted. A portion of the revenue earned by the assessee had been set apart and kept in a reserve fund for some specific purposes of the assessee. That fund belonged to the assessee, the assessee had the use of it. Under those circumstances, it could not be said that there had been any diversion of income at source by an overriding title from the assessee or that the amount that had been appropriated did not form part of the real income of the assessee. It was contended before the Calcutta High Court that the appropriation to the Contingencies Reserve was, in any event, expenditure wholly and exclusively laid out for the assessee’s business and should be allowed as a deduction. This argument was not accepted for the appropriation that had been made was not towards any known liability. The money had been set apart for meeting unknown future liabilities. It was not a provision but a reserve. There had been no expenditure in the real sense of the term.
Mr. Sachar, learned counsel for the assessee before us, submitted that there was no distinction between the Consumers’ Benefit Reserve which had been considered by the Supreme Court in the case of Poona Electric Supply Co. Ltd. and the Contingencies Reserves. The argument is fallacious. We have quoted the appropriated passage of this Court’s earlier judgment. The emphasis is on the fact that the amount paid into the Consumers’ Benefit Reserve has to be returned to the consumers. Therefore, it is as if the electricity company had not received the amount which it was obliged to return. The amount that it was obliged to return was not a part of its income. This is altogether different from the case of monies standing to the credit of the Contingencies Reserve which are set apart to be utilised by the electricity company for the purposes set out in clause V of the Sixth Schedule. These are to meet expenses or recoup loss of profits arising out of accidents, strikes or other circumstances which the electricity company could not have prevented; to meet expenses on replacement or renewal of plant or works; and for payment of compensation required by law for which no other provision has been made. These are all expenses which the electricity company has to incur.The reservation is made so that money is always available for meeting these expenses and the supply of electricity is not interrupted. For the same reason, payments out of the Contingencies Reserve can be made only with the State Government’s approval. It is particularly noteworthy that the electricity company can make good from out of the Contingencies Reserve even a loss of profit arising out of strikes, accidents and other circumstances over which it has no control. There can be no doubt, in the circumstances, that the monies in the Contingencies Reserve belong to the electricity company.
The application of the doctrine of diversion of income by reason of an over-riding title is quite inapposite. The doctrine applies when, by reason of an over-riding title or obligation, income is diverted and never reaches the person in whose hands it is sought to be assessed [See CIT vs. Sitaldas Tirathdas, 41 I.T.R. 367 (S.C.).] In the present case, the statute requires the electricity company to create certain reserves if its clear profit exceeds a reasonable return (clause II, Sixth Schedule). Again, the Contingencies Reserve is to be created from existing reserves or from "the revenues of the undertaking". This clearly indicates that the monies which have to be put into the Contingencies Reserve reach the electricity company and are not diverted away from it.
It is the electricity company which has to invest the sums appropriated to the Contingencies Reserve. The investment would be in its name and it would be the owner thereof. The restriction that the investment can be made only in securities mentioned in the Indian Trusts Act makes no difference to this position.
That on the purchase of the undertaking the Contingencies Reserve has to be handed over to the purchaser and maintained as such is only to make explicit the obvious for the reserve is for the purposes of the undertaking that is being transferred. There is nothing in the statute to suggest, as argued, that the amount standing to its credit cannot be taken into consideration in arriving at the purchase price. For the purposes of sale to a State Board or Government, a different statute lays down how the price is to be fixed, and with it we are not here concerned.
We must add that we asked Mr. Sachar to whom, in his submission, the amounts credited to the Contingencies Reserve were diverted. Mr. Sachar replied that they were diverted to and vested in the State Government. This, for the reasons set out above, is quite unacceptable.
We hold that the amount credited to the Contingencies Reserve is not diverted by reason of an overriding obligation or title and, in determining the business profits of the assessee, it must be taken into account.
Mr. Sachar contended that if the amount credited to the Contingencies Reserve was includible in the computation of the business income of the assessee, the amount so appropriated should be allowed as a business deduction, being expenditure necessary to carry on the assessee’s business. As the Calcutta High Court has pointed out, there is no expenditure. The amount appropriated to the Contingencies Reserve is set apart to meet possible exigencies. It is not a provision for known, existing liabilities.
In the result, the identical question referred to us in the three references is answered in the affirmative and in favour of the Revenue.
The assessee shall pay to the Revenue the costs of the references, quantified in the sum of Rs.10,000/-.