Holding

The amounts set apart for bad and doubtful debts are reserves, not provisions, and qualify for relief under the Companies (Profits) Surtax Act, 1964.

Summary

The State Bank of Patiala had, in several assessment years, transferred sums to a "bad and doubtful debts" account and claimed that these amounts were "reserves" under the Companies (Profits) Surtax Act, 1964, thereby eligible for statutory deduction. The Income Tax Officer rejected the claim, but the Income Tax Appellate Tribunal allowed it, holding the amounts were reserves. The Punjab & Haryana High Court reversed the Tribunal, treating the sums as provisions and denying the relief. The Supreme Court examined the distinction between reserves and provisions, emphasizing that a reserve is an appropriation of profit not intended to meet a known or anticipated liability, whereas a provision is a charge against profit for such liabilities. Since the bank had not written off any bad debts, had not claimed any deduction for them, and the amounts remained in the capital, the Court held they were reserves within the meaning of Rule 1(xi)(b) of the First Schedule and Rule 1(iii) of the Second Schedule. Consequently, the Court restored the Tribunal's order and allowed the appeals, granting the bank the appropriate relief.

Issues considered

Whether amounts set aside by a banking company for "bad and doubtful debts" without actual write‑off constitute a "reserve" under Rule 1(xi)(b) of the First Schedule and Rule 1(iii) of the Second Schedule of the Companies (Profits) Surtax Act, 1964.

Legislation cited

Companies (Profits) Surtax Act, 1964s. 2(5), s. 2(8), s. 4, s. First Schedule Rule 1(xi)(b), s. Second Schedule Rule 1(iii)
Income Tax Act, 1961

Subjects

Companies (Profits) Surtax ActReserve vs ProvisionBad and doubtful debtsStatutory deductionBanking companyChargeable profitsCapital computationIncome tax

Judgment

STATE BANK OF PATIALA, PATIALA A
v.
~·,
THE COMMISSIONER OF INCOME-TAX, PATIALA ·

MARCH 13, 1996

[B.P. JEEVAN REDDY AND K.S. PARIPOORNAN, JJ.] B

Companies (Profits) Surtax Act, 1964:

Sections 2(5)(8) and (9) and 4-First Schedule-Rule l(xi)(b)-
Second Schedule-Rule I (iii). C
Banking Company-Reserve-Setting apart amounts for 'bad and
doubtful debts'-No amount of bad debt actually w1itte11 off of adjusted
against Uie amount claimed as reserves-No claim for deduction made dwing
. the relevant assessment year;--Amount remained in the account books of
assessee as capital-Assessee treating the amount as 'rese1ve' and not as D
'provisions'-Held amount set apart are 'reserves' qualifying for relief under
Rule J(xi)(b) of First Schedule and Rule l(iii) of Second Schedule.

The question in these appeals is whether the amounts set apart by
the assessee for "bad and donbtful debts" in the balance sheets of the
relevant period constitute "reserve" as contemplated by Rule l(xi) (b) of E
the First Schedule and Rule l(iii) of the Second Schedule to the Companies
(Profits) Snrtax Act, 1964? The appellant-assessee set apart amounts as
"reserve" for "bad and doubtful debts" for the assessment years 1971-72,
1972-73, 1973-74, 1975-76 and 1985-86. Its claim that such sums qnalified
as reserves for the purpose of Rule 1 (xi)(b) of the First Schedule and Rule F
• l(iii) of the Second Schedule of the Act and such sums, representing
reserves, should be included in the capital of the appellant for appropriate
relief was rejected by the Income Tax Ollicer. On appeal the Income Tax
Appellate Tribunal upheld the plea of the assessee and held that the
amounts set apart as reserves are entitled for appropriate relief under
Rule l(xi)(b) of the First Schedule and Rule l(iii) of the Second Schedule G
of the Act. At the instance of Revenue a reference was made to the High
Court which held that on the facts and circumstances of the case, sums of
11
money set apart by the assessee as reserves are really provisions and not
11

"reserves" and so such sums are not entitled to the relief granted by the
Appellate Tribunal. Against the decision of the High Court, assessee H
359
360 SUPREME COURT REPORTS [1996] 3 S.C.R.

A preferred appeals before this Court.
AJl01>fog the appeals, this Court

HELD : 1. The amounts set apart towards bad and doubtful debts
in these cases are "reserves" qualifying for appropriate relief under rule
B l(xi)(b) of the First Schedule and rule l(iii) of the Second Schedule to the
Companies (Profits) Surtax Act, 1964. (374-D]

2. The Act has levied a charge on every company for every assessment
year - a tax called sur-tax - in respect of so much of its chargeable profits
of the previous years as exceed the statutory deduction at the rates
C specified in the Third Schedule. In determining the chargeable profits,
Rule l(xi)(b) of the First Schedule mandates that in the case of a banking
company any sum transferred by it during the previous year to any
reserves in India including the reserves not shown as such in its published
balance sheets in so Car as the sums transferred to such reserves are
D attributable to income chargeable to tax under the Income-tax Act and
have not been allowed as a deduction in compnting its total income under
the Act, shall be exclnded. The tax is levied, on the chargeable profits,
which excluded the statutory deduction at the rates specified in the Third
Schedule. As per section 2(8) or the Act statutory deduction is defined to
E mean an amount equal to ten per cent of the capital of the company as
computed in accordance with the provisions of the second Schedule. Rule
1 of the second Schedule mandates that the capital of the company shall
be the aggregate of the amounts taking within its fold its other reserves as
specified in Rule l(iii) or the Second Schedule. (367-B-E]

F 3. If the sums set apart in the balance sheets are only "provisions"
•
the assessee will not be entitled to the relief claimed by it. Ir, on the other
hand, the sums set apart are "reserves" within the meaning or the Act, the
assessee will be entitled to appropriate relier. [367-F)

4. If the transfer of amount is made ad hoc, when there is no known
G or anticipated liability, such fund will only be treated as 'reserve'. In this
case, substantial amounts were set apart as reserves. No amount of bad
debt was actually written off or adjusted against the amount claimed as
reserves. No claim for any deduction by way of bad debts were made during
the relevant assessment years. The assessee never appropriated anl'.
H amount against any bad and doubtful debts. The amounts throughout
STATE BANK OFPATIALAv. C.I.T. 361

remained in the account of the assessee by way of capital and the assessee A
treated the said amounts as "reserves" and not as "provisions" designed to
meet liability, contingency, commitment or diminution in the value of
assets known to exist at the relevant dates of balance sheets. These facts
have been found by the Tribunal. On the facts, the amount set apart as
reserves cannot be said to be so ear marked, when any liability has actually B
arisen or was anticipated by the assessee. It cannot b.e said either, that the
amounts set apart out of the profits were designed to meet any known
liability, that existed on the date of the balance-sheet. [373-H; 374-A-C]

Metal Box Co. of India Ltd. v. Their Workmen, 73 ITR 53; Vazir Sultan
Tobacco Co. Ltd. v. Commissioner of Income-Tax, A.P., 132 ITR 559; C
Commissioner of Income-Tax, Kanpur v. Elgin Mills Ltd., 161 ITR 733 and
C.I. T. v. Saran Enginee1ing Co. Ltd., 161 ITR 741, explained and relied on.

Commissioner of Income-Tax v. State Bank of Patiala, 203 ITR 150,
disapproved. D

5. The observations of this Court that the liability should be one
''which bas actually arisen or is anticipated legitimately by the assessee",
cannot be extended to hold, that in the case of an assessee carrying on
banking business, it is "bound11 or "can reasonably anticipate" on the date E·
of the preparation of balance sheet "bad and doubtful debts", for which "it
ought", in anticipation, makes a provision and such provision for an ..
ticipated liability should be equated with known and existing liability and
should be construed as a provision. The question in such cases is whether
the liability was "known" or "anticipated" on the date when the balance
• sheet was prepared. The question is not whether the assessee can an..
11 F
ticipate" or "reasonably anticipate" on the date when the balance sheet was
prepared about "the bad and doubtful debts". The High court was in error
in surmising that the assessee being a banking company is bound to have
bad and doubtful debts. It need not necessarily be so. It is not bound to
anticipate on the date of preparation of balance sheet that all or any of its G
debts "are bound to be bad and doubtful". It all depends upon ,facts and
circumstances. [375-B-E]

Observations in C.I.T. v. Saran Engineering Co. Ltd., 161 ITR 741,
explained. H
362 SUPREME COURT REPORTS [1996] 3 S.C.R.

A CIVIL APPELLATE JURISDICTION : Civil Appeal Nos. 4270-
4273 Of 1996 Etc. Etc.

From the Judgment and Order dated 27.7.92 of the Punjab &
Haryana High Court in l.T.R. Nos. 235 to 238 of 1980.

B G.C. Sharma, A.D.N. Rao and A. Subba Rao for the Appellants.

B.S. Ahuja for the Respondents.

The Judgment of the court was delivered by

C PARIPOORNAN, J. Leave granted in all the special leave petitions.

2. These are all connected cases. The matter arises under the Com-
panies (Profits) Surtax Act, 1964 (hereinafter referred to as the Act). The
parties in all the appeals are the same. The appellant in the appeals is "The
State Bank of Patiala" and the respondent is the "Commissioner of Income
D tax, Patiala". The Civil Appeals filed from Special leave petitions (C) Nos.
2392-95 of 1993 are the main cases. They relate to four assessment years -
1971-72, 1972-73, 1973-74 and 1975-76. The appellant-assessee set apart
amounts as "reserve" for "bad and doubtful debts" in all the years. A claim
was laid that such sums qualified as reserves for the purpose of Rule 1 (xi)
E (b) of the First Schedule and Rule 1 (iii) of the Second Schedule of the
Act and such sums, representing reserves, should be included in the capital
of the appellant for appropriate relief. The Income Tax Officer rejected
the claim. In appeal, the income Tax Appellate Tribunal allowed the plea
of the assessee. The Income Tax Appellate Tribunal, by its detailed order
F dated 23.1.1980, upheld the plea of the assessee and held that the amounts
set apart as reserves are entitled for appropriate relief under rule 1 (xi)
(b) of the First Schedule and Rule l(iii) of the Second Schedule of the Act.
On motion by the Revenue the Appellate Tribunal referred the following
questions of law for the decision of the High Court of Punjab and Haryana,
G which were numbered as Income Tax Reference Nos. 235 to 238 of 1980 :

"(i) Whether, on the facts and in the circumstances of the case,
the Appellate Tribunal was right in law in holding that the amounts
provided by the assessee for bad and doubtful debts in the balance
sheets of the relevant previous years qualified as rese1ves for the
H purpose of clause (xi)(b) of rule I of the First Schedule to the
STATEBANKOFPATIALAv. C.l.T. [PARIPOORNAN, J.] 363

Companies (Profits) Sur-tax Act, 1964 and consequently allowing A
yearwise deduction as under :

1971-72 Rs. 7,00,000
1972-73 Rs. 13,78,000
1973-74 Rs. 22,11,000
1975-76 . Rs. 15,98,000 B

·•· (ii) Whether, on the facts and in the circumstances of the case, the
Appellate Tribunal was right in law in holding that the amounts
of Rs. 10,53,576, Rs. 27,21,641, Rs. 29,91,641 and Rs. 47,16,641
provided for bad and doubtful debts as at the beginning of the C
relevant accounting year respectively for the assessment years 1971-
72, 1972-73, 1973-74 and 1975-76 qualified as a reseive for inclusion
in the capital of the assessee under Second Schedule to the
Companies (Profits) Sur- tax, Act, 1964." (emphasis supplied)

By a detailed judgment dated 27.7.1992 the High Court took the view that D
on the facts and circumstances of the present case, sums of money set apart
)Ii by the assessee as reserves are really "provisions" and not "reserves" and
, so, such sums are not entitled to the relief granted by the Appellate
Tribunal. It is, thereafter the assessee moved this Court by special leave
petition Nos. 2392-95 of 1993 and obtained special leave in the four cases. E
The judgment of the High Court is reported as Commissioner of Income
Tax v. State bank of Patiala 203 !TR 150.

3. Special leave petitions (C) Nos. 27543-50 of 1995 relate to the same
assessee and eight assessment years are involved therein - 1979-80 to
1987-88 except 1985-86. For those years, identical claim put forward by the F
• appellant-assessee was rejected by the Income Tax Officer. In appeal, CIT
allowed the claims. In the meanwhile, the decision of the High Court for
. the previous four years, i.e., 1971-72, 1972-73, 1973-74 and 1975-76 had
been rendered and so the Tribunal, following the decision of the High
Court, held against the assessee. The plea of the assessee to refer the G
matter either to the appropriate High Court or to this Court was disal-
lowed. The ass.essee has filed special leave petitions in this Court directly
against the aforesaid order of the Appellate Tribunal.

4. Special leave petition (C) No. 27551 of 1995, relating to the same
assessee and involving consideration of the same question, relates to the H
364 SUPREME COURT REPORTS [1996] 3 S.C.R.

A assessment year 1985-86. The Appellate Tribunal finally decided against
the assessee following the earlier decision of the High Court reported in
203 ITR 150. The attempt to get the matter referred to the High Court was
unsuccessful and so the assessee filed the special leave petition in this
Court against the order of the Appellate Tribunal.

B 5. All the 13 appeals involve consideration of the same question
between the same parties. So, they were heard together and are disposed
of by this common judgment.

6. We heard counsel for the appellant-assessee, Mr. A. Subba Rao,
C and counsel for the respondent-Revenue, Mr. B.S. Ahuja.

7. The statutory provisions, relevant for our purpose, are mentioned
hereinbelow :

171e Companies (Profits) Surtax Act, 1964 (Act 7 of 1964)
D
"2(5) "Chargeable profits" means the total income of an assessee
computed under the Income-tax Act, 1961 for any previous year :.
or years, as the case may be, and adjusted in accordance with the
provisions of the First Schedule;
E
xxxx xxxx xxxx xxxx

(8) "Statutory deduction" means an amount equal to fifteen per
cent of the capital of the company as computed in accordance with
the provisions of the Second Schedule, or an amount of two
F hundred thousand rnpees, whichever is greater :

Provided that where the previous year is longer or shorter than
a period of twelve months, the aforesaid amount of fifteen per cent
or, as the case may be, of two hundred thousand rnpees shall be
increased or decreased proportionately:
G
Provided further that where a company has different previous
years in respect of its income, profits and gains, the aforesaid
increase or decrease, as the case may be, shall be calculated with
reference to the length of the previous year of the longest duration;
H and ·
STATEBANKOFPATIALAv. C.l.T. [PARIPOORNAN,J.] 365

(9) all other words and expressions used herein but not defined A
and defined in the Income-Tax Act shall have the meanings respec-
tively assigned to them in that Act."

"4, Charge of tax. - Subject to the provisions contained in this Act,
there shall be charged on every company for every assessment year
commencing on and from the first day of April, 1964 (but before B
the first day of April, 1988), a tax (in this Act referred to as the
surtax) in respect of so much of its chargeable profits of the previous
year or previous years, as the case may bt;, as exceed the statutory
deduction, at the rate or rates specified in the Third Schedule."

"THE FIRST SCHEDULE"
c
(See Section 2(5))

RULES FOR COMPUTING THE CHARGEABLE PROFITS
D
In computing the chargeable profits of a previous year, the
total income computed for that year under the Income-Tax Act
shall be adjusted as follows :

1. Income, profits and gains and other sums falling within the
following clauses shall be excluded from such total income, namely: E

xxxx xxxx xxxx

(xi) in the case of a banking company -

(a) any_ sum which during the previous year is transferred by it F
to a reserve fund under sub-section (1) of section 17 of the
Banking Companies Act, 1949 or is deposited by it with the
Reserve Bank of India under sub-clause (ii) of clause (b) of
sub-section (2) of section 11 of that Act, not exceeding the
amount· required under the aforesaid provisions to be so G
transferred or deposited, as the case may be, or

(b) any sum transferred by it during the previous year to any
reserves in India including reserves not shown as such in .its
published balance sheet in so far as the sums transferred to
such reserves are attributable to _income chargeable to tax H
366 SUPREME COURT REPORTS [1996] 3 S.C.R.

A under the Income-tax Act and have not been allowed as a
deduction in computing its total income under that Act and
in so far as the aggregate of such sums does not exceed the
highest of the aggregate of such sums, if any, so transferred
during any one of the three years prior to the previous year,
whichever is higher;
B
xxxx xxxx xxxx xxxx

(Explanation - Notwithstanding anything contained in any clause

c
of this rule, the amount of any income or profits and gains which
is required to be excluded from the total income under that clause ..
shall be only the amount of such income or profits and gains as
computed in accordance with the provisions of the Income-tax Act
(except Chapter VIA thereof), and in a case where any deduction
is required to be allowed in respect of any such income or profits
and gains under the said Chapter VIA, the amount of such income
D or profits and gains computed as aforesaid as reduced by the
amount of such deduction.)"

''THE SECOND SCHEDULE"

(See Section 2(8))
E
RULES FOR COMPUTING THE CAPITAL OF A COMPANY FOR
THE PURPOSES OF SURTAX

l. Subject to the other provisions contained in this Schedule, the
capital of a company shall be the aggregate of the amounts, as on
F the first day of the previous year relevant to the assessment year •
of-

(i) ....................................... ..

G (ii) ...................................... ..

(iii) its other reserves as reduced by the amounts credited to such
reserves as have been allowed as a deduction in computing
the income of the company for the purposes of the Indian
Income-tax Act, 1922 or the Income-tax Act, 1961;' (emphasis
H supplied)
STATE BANK OF PATIALA v. C.I.T. [P ARIPOORNAN, J.} 367

8. The facts of these cases are not in dispute. As stated by the High A
Court the sole point, which falls for consideration, is whether the amounts
set apart by the assessee during each assessment year for "bad and doubtful
debts" in the balance sheets of the relevant period constitute "reserve" as
contemplated by Rule 1 (xi) (b) of the First Schedule and Rule 1 (iii) of
the Second Schedule to the Act? The Act has levied a charge on every B
company for every assessment year - a tax called sur-tax - in respect of so
much of its chargeable profits of the previous years as exceed the statutory
deduction at the rates specified in the Third Schedule. In determining the
chargeable profits, Rule 1 (xi) (b) of the First Schedule mandates that in
the case of a banking company any sum transferred by it during the
previous year to any reserves in India including the reserves not shown as C
such in its published balance sheets in so far as the sums transferred to
such reserves are attributable to income. chargeable to tax under the
Income-tax Act and have not been allowed as a deduction in computing its
total income under the Act, shall be excluded. The tax is levied, on the
chargeable profits, which excluded the statutory deduction at the rates D
specified in the Third Schedule. As per section 2(8) of the act statutory
;< deduction is defined to mean an amount equal to ten per cent of the capital
of the company as computed in accordance with the provisions of the
Second Schedule. Rule 1 of the Second Schedule mandates that the capital
of the company shall be the aggregate of the amounts taking within its fold
its other reserves as specified in Rule 1 (iii) of the Second Schedule. E

9. If the sums set apart in the balance sheets are only "provisions" the
assessee will not be entitled to the relief claimed by it. If, on the other hand,
the sums set apart are 11 reserves'1 within the meaning of the Act, the assessee
will be entitled to appropriate relief. After referring to the relevant F
decisions, dealing with the reserves and provisions, the Income Tax Appel-
late Tribunal posed the question thus :

11
in order to constitute a reserve a particular amount set
................

aside out of the profits and other surpluses, not designed to meet
a liability, contingency, commitment or diminution in the value of G
assets known to exist at the date of the balance sheets, is a reserve.
In other words, if the amount set apart is designed to meet a
liability, contingency, commitment or results in diminution in value
of assets, it would be a provision and not a reserve. We have '.o
apply this test here ......... " H
368 SUPREME COURT REPORTS [1996] 3 S.C.R.

A In paragraphs 20 to 22 of its order, the Appellate Tribunal entered the
following findings :

"We find that the assessee has not written off or adjust (ed) these
amounts provided as reserves and doubtful debts in its profit and
loss account that these amounts have not been allowed as a
B deduction computing the income of the company for purposes of
Income-tax Act, that these amounts have remained employed in
the business of the assessee by way of capital and the assessee has
in fact treated these amounts as reserves and not as provisions
designed to meet a liability, contingency, commitment, or diminu-
c tion in the value of assets known to exist at date of relevant balance
sheets. We, therefore, hold that these are amounts which constitute
reserve for clause (iii) of rule 1 of the Second Schedule to the
Companies (Profits) Sur-tax Act, 1964."

"In fact it has been clarified by the learned Counsel for the
D assessee, and it has not been controverted by the revenue, that in
none of the years under appeal the assessee appropriated any
amounts against bad and doubtful debts. The reserves stood as
they were in each year and therefore, would constitute rese1ve within
the meaning of ntle 1(xi)(b) of the Second Schedule to the Com-
E panies (Profits) Sur-tax Act, 1964."

(emphasis supplied)

In paragraph 24 of its order the Tribunal concluded thus : -

F "We also find that no amount on account of bad debts was
factually written off or adjusted by the assessee against these
amounts claimed as reserves, that in fact the assessee also did not
make a claim for any deduction for any of the assessment years
under consideration on account of bad debts, that no such claim
was either made or allowed by the Income-tax Officer that the
G assessee made contra entries in the unpublished balance sheets
only and no such entries were passed in books and that the
published balance-s.hects did not contain any contra entries. The
amounts were in fact treated as reserves. These are entitled to be
considered as reserves under Rule l(xi)(b) of the First Schedule
H to the Act. We, therefore, direct that these be so treated. Both the
STATEBANKOFPATIALAv. C.J.T. [PARIPOORNAN, J.] 369

issues are decided in all the assessment years, in favour of the A
assessee.n
_.\..
(empha<is supplied)

10. The High Court, in answering the questions referred to it, by
judgment dated 27.7.1992, adverted to the landmark decisions of this Court B
in Metal Box Co. of India Ltd. v. 77ieir workmell, 73 !TR 53; Vazir Sultan
Tobacco Co. Ltd. v. Commissioner of Income-Tax, A.P., 132 !TR 559;
Commissioner of Illcome-Tax, Kanpur v. Elgin Mills Ltd., 161 !TR 733 and
C.l. T. v. Saran Enginee1ing Co. Ltd., 161 !TR 741,-and stated thus :

"Thus, where a fund has been created to meet a liability which has c
actually misen and is known on the date of the preparation of the
balance-sheet, it would obviously be a provision. Again, ftmd
created or a sum of molley set apart to meet ally liability which the
assessee call reasonably and legitimately allticipate Oil the date of
preparation of the balance sheet though the quantum of that liability D
is not yet detennined, has also been equated with the present known
J( liability and the fund to meet such liability cannot be treated as a
rese1ve. If on the other had a fund is created to meet some future
unknown liability which has not yet a1isen and which could not
legitimately and reasonably be anticipated by the assessee at the
time of the preparation of the accounts, the fund would be treated
E
as a 'reserve'. Whether in respect of bad and doubtful debts, an
account could be treated as reserve or a provision would depend
upon the facts and circumstances of each case. Again, whether a
., particular liability could reasonably and legitimately be anticipated
~ by the assessee on the date of the balance sheet would be a question F
of fact to be determined in the circumstances of each case and the
nature of the business carried on by the assessec would be one
relevant factor.

Applying these tests to the case in hand, one cannot loose sight
of the fact that the assessee before us is a banking company whose G
primary business, is to lend money. In the very nature of things, it
~·.
would be reasonable and legitimate for such an assessee to assume
that in the course of its business, it is bound to have bad and doubtful
debts for which it may in anticipation make a provision in the balance
sheet by having a separate ftmd or an account to meet such H
370 SUPREME COURT REPORTS [1996] 3S.C.R.
A anticipated liability although its qualltum would be detennined at
some later date. Si11ce such a11ticipated liability has been equated
with k11ow11 and existi11g liability, the ftmd is to be co11sidered a
'provision' and not a 'reserve'.n

(emphasis supplied)
B
The High Court concluded, thus :

"For the reasons recorded above, we are or the view that on
the facts and circumstances of the present case, the sums of money
set apart by the assessee herein for meeting its a11ticipated liability
c was a 'provision' and the Tribunal erred in law in holding it to be
a 'reserve'. In the result, both the questions referred to us are
answered in the negative i.e. against the assessee and in favour of
the Revenue."

D (emphasis supplied)

11. We are of the view that the learned judges of the High Court ~
misunderstood and misapplied the ratio laid down in the decisions of this
Court, referred by it. In Metal Box Co. of India Ltd. v. Their workmen 73
E /TR 53 at pp. 67-68 this Court laid down the law thus :

"The next question is whether the amount so provided is a
provision or a reserve. The distinction between a provision and a
reserve is in commercial accountancy fairly well known. Provisions
made against anticipated losses and contingencies are charges
F against profits and, therefore, to be taken into account against
gross receipts in the P & L account and the balance-sheet. On the
other hand, reserves are appropriations of profits, the assets by
which they are represented being retained to form part of the
capital employed in the business. Provisions are usually shown in
the balance-sheet by way of deductions from the assets in respect
G of which they are made whereas general reserves and reserve funds
are shown as part of the proprietor's interest (see Spicer and
Pegler's Book-keeping and Accounts, 15th edition, page 42). An
amount sat aside out of profits and other surpluses, 11ot designed
to nteet a liability, contingenc>~ contmillnent or dilninution in the
H value of assets known to exist at the date of the balance-sheet is a
STATE BANK OF PATIALAv. C.J.T. [PARIPOORNAN, J.] 371

reserve but an amount set aside out of profits and other surpluses A
to provide for any known liability of which the amount cannot be
.A determined with substantial accuracy is a provision (see William
Pickles Accountancy, second edition, p.192; Part III, clause 7,
Schedule VI to the Companies Act, 1956, which defines provision
and reserve).n
B
(emphasis supplied)

In Vazir Sultan Tobacco Co. Ltd. v.. Commissioner of Income-Tax, A.P.,
{supra), after referring to the above observations in Metal Box Company's
case (supra), the court held at p. 569, thus :
c
"Jn other words the broad distinction between the two is that
whereas a provision is a charge against the profits to be taken into
account against gross receipts in the P. & L account, a reserve is
an approp1iatio11 of profits, the asset or assets by which it is
represented being retained to form part of the capital employed D
in the business." {emphasis supplied)
;(
After referring to the relevant provisions of Companies Act, 1956 regarding
the form of balance-sheet wherein the words "reserve and surplus" and
"current liabilities and provisions" etc. are dealt with, the Court observed,
thus: E

"On a plain reading of cl. 7(1)(a) and {b) and cl. 7(2) above it
will appear clear that though the term "provision" is defined posi-
lively by specifying what it means the pefinition of "reserve" is
, "f negative in form and not exhaustiye 11' \he sense that it only F
specifies certain amounts which are not to be included in the term
'reserve". In other words the effect ofreading the two definitions
together is that if any retention or appropriation of a sum falfa
within the definition of 'provision' it can never be a reserve but it
does not follow that if the retention or appropriation is not a

... provision it is automatically a reserve and the question will have
to be decided having regard to the true nature and character of
the sum so retained or appropriated depending on several factors
G

including the intention with which and the purpose for which such
retention or appropriation has been made because the substance
of the .mater is to be regarded and in this collle.>t the primary H
372 SUPREME COURT REPORTS (1996) 3 S.C.R.

A dictionary meaning of the tenn "rese1Ve" may have to be availed of.
But it is clear beyond doubt that if any retention or appropriation
of a sum is not a provision, that is to say, if it is not designated to
meet depreciation, renewals or diminution in value of assets or any
known liability the same is not necessarily a reserve. We are
emphasising this aspect of the matter because during the hearing
B
almost all counsel for the assessees strenuously contended before
us that once it was shown or became clear that the retention or
appropriation of a sum out of profits and surpluses was for an
unknown liability or for a liability which did not exit on the relevant
date it must be regarded as a reserve. The fallacy underlying the
c contention becomes apparent if the negative and non-exhaustive
aspects of the definition of reserve are borne in mind. Having
regard to the type of definitions of the two concepts which are to
be found in cl. 7 of Pt. III the proper approach in our view would
be first to ascertain whether the particular retention or appropria-
tion of a sum falls within the expression "provision" and if it does
D
then clearly the concerned sum will have to be excluded from the
computation of capital, but in case the retention or appropriation
of the sum is not a provision as defined, the question will have to
be decided by reference to the true nature and character of the
sum so retained or appropriated having regard to several factors
E as mentioned above and if the concerned sum is in fact a reserve
then it will be taken into account for the computation of capital."

(emphasis supplied)

F In Commissioner of Income-Tax, Kanpur v. Elgin Mills Ltd. (supra) the
Court stated the guidelines to be borne in mind to distinguish between
'provision' and 'reserves' in the following words :

"The distinction between !!provision" and "reserve" must be found
out bearing in mind the main features of the reserve. These are :
G (1) it must be an appropriation of profits, current or accumulated,
and not a charge against the profits for the year. (2) The conduct
of the parties must bear out that intention. (3) It must not be to
. ,..
set apart to meet any known liability - a liability known to exist on
the date of the balance-sheet. Reference in this connection may
H be made to the observations of this Court in Vazir Sultan's case
STATE BANK OFPATIALAv. C.J.T. [PARIPOORNAN, J.] 373

(1981) 132 !TR 559 at pages 569-570." A
Again, in Commissioner of Income-Tax v. Saran Engineering Co. Ltd.,
(supra) dealing with the question as to whether bad and doubtful debts will
constitute a 'provision' or 'reserve', the Court stated, thus :

"Bad and Doubtful Debts Reserve was created in 1956 through B
the Profit and Loss Appropriation account. The amount involved
was Rs. 5,00,000. It was submitted on behalf of the assessee by Shri
Salve that this was created by transfer from the appropriation
account and not as a charge against profit. Furthermore, a separate
provision was made for bad and doubtful debts which provision C
was reduced from the value of the assets. It was not the Revenue's
case that the provision for bad and doubtful debts provided was
less than the amount reasonably necessary to be provided. If the
amount, as it appears to be, is 111ore than the a1noztnt reasonably
necessary to be provided in respect of bad and doubtful debts, then
it constituted a "reserve". It is not correct to state that by the very D
nomenclature, this was not a reserve. The true nature of the
transaction has to be examined."

(emphasis supplied)
E
And again at p. 748 the Court concluded, thus :

"It may be mentioned that where the liability has actually arisen or
is anticipated legitimately by the assessee though the quantum of the
liability has not been determined, a fund to meet such present
• liability cannot be treated as "reserves". A fund, however, created
for payment of a liability which had not already arisen or fallen due
F

but is only a provision with regard to the sum that might become
liable to be paid is "other reserves" within the meaning of rule 1
of the Second Schedule and shoulU be taken into account in
computing the capital of the company for the purpose of the G
Companies (Profits) Surtax Act, 1964."

(emphasis supplied)

12. A fair reading of the above decisions would go to show that if the
transfer of amount is made ad hoc, when there is no known or anticipated H
374 SUPREME COURT REPORTS [1996] 3 S.C.R.

A liability, such fund will only be treated as 'reserve'. In this case, substantial
amounts were set apart as reserves. No amount of bad debt was actually
written off or adjusted against the amount claimed as reserves. No claim
for any deduction by way of bad debts were made during the relevant
assessment years. The assessee never appropriated any amount against any
B bad and doubtful debts. The amounts throughout remained in the account
of the assessee by way of capital and the assessee treated the said amounts
as '1reserves 11 and not as 11provisions11 designed to meet liability, contingency,
commitment or diminution in the value of assets known to exist at the
relevant dates of balance sheets. These facts have been found by the
C Tribunal. On the facts, the amount set apart as reserves cannot be said to
be so earmarked, when any liability has actually adsen or was anticipated by
the assessee. It cannot be said either, that the amounts set apart out of the
profits were designed to meet any known liability, that existed at the date of
the balance-sheet. Tested in the light of the decisions of this Court, referred
to hereinabove, it appears to us, that the amounts set apart towards bad
D and doubtful debts in these cases are "reserves" qualifying for appropriate
relief under rule l(xi) (b) of the first Schedule and rule l(iii) of the Second
Schedule of the Act. X

13. We are afraid that the High Court has grossly misunderstood the
E following observations of this Court contained in Commissioner of Income- .
Tax v. Saran Enginee1ing Co. Ltd. (161 ITR 741) at p. 748.

"It may be mentioned that where the liability has actually arisen or
is anticipated legitimately by the assessee though the quantum of the
liability has not been determined, a fund to meet such present
F liabil.ity cannot be treated as nreservesn.n

(emphasis supplied)

14. The High Court has taken the view that the "fund created or a
G sum of money set apart to meet any liability which the assessee "can
reasonably arid legitimately a11ticipate" on the date of preparation of the
balance sheet, is the same, as in a case "where the liability has actually • ll
arisen", (a present known liability) and the fund to meet such liability
cannot be treated as reserve". In the view of the High Court, since the
H assessee is a banking company, it would be reasonable and legitimate to
STATE BANKOFPATIALAv. C.l.T. [PARJPOORNAN,J.] 375

assume" that .in the course of its business, "it is bound to have" bad and A
doubtful debts for which "it may'~ in anticipation, make a provision in the
balance sheet by having a separate fund or an account to meet such
anticipated liability. We are afraid that the aforesaid assumption is totally
unjustified and proceeds on mere surmises and conjectures. This is not a
case, when at the time fund is earmarked, there is a known liability - one B
which has either arisen or anticipated legitimately, by the assessee - and
the fund to meet such eventuality cannot be treated as "reserves". The
observations of this Court that the liability should be one "which has
actually arisen or is anticipated legi,timately by the assessee", cannot be
extended to hold, that in the case of an assessee carrying on banking C
business, it is 11 bound11 or 11 can reasonably anticipate11 on the date of the
preparation of balance sheet "bad and doubtful debts", for which "it ought",
in anticipation, make a provision and such provision for anticipated liability
should be equated with known and existing liability and should be con-
strued as a provision. The question in such cases, is whether the liability
was "known" or. "anticipated" on the date when the balance sheet was D
prepared. The question is not whether the assessee "can anticipate" or
"reasonably anticipate" on the date when the balance sheet was prepared
about "the bad and doubtful debts". The High Court was in error in
surmising that the assessee being a banking company is bound to have bad
and doubtful debts. It need not necessarily be so. It is not bound to E
anticipate on the date of preparation of balance sheet that all or any of its
debts "are bound to be bad and doubtful". It all depends upon facts and
circumstances. We are of the view that the High Court misunderstood the
scope of the observations in Saran Engineering Co.'s case (supra) and
surmised that the observations quoted at page 748 will even cover cases, F
where the liability was not factually anticipated on the date of the prepara-
tion of the balance sheet, but also will apply to cases, where the company
"ought and can" anticipate on the date of preparation of the balance sheet.

14. We set aside the judgment of the High Court, rendered in !TR
No. 235-238 of 1990 dated 27.7.1992 and restore the order passed by the G

--
Appellate Tribunal dated 23.1.1980. We answer the questions, referred to
the High Court, in the affirmative, in favour of the assessee and against the
Revenue.

15. It was agreed that the decisions taken in special leave petitions H
r

376 SUPREME COURT REPORTS [1996] 3 S.C.R.

A Nos. 2392-95/93 for the assessment years 1971-72, 1972- 73, 1973-74 and
1975-76 will cover the other cases as well. Therefore, we hold that the
assessee is entitled to the appropriate relief for the years 1979-80 to
1987-88 as well, which are covered by the other two sets of appeals.

16. The appeals are allowed. There shall be no order as to costs.
B
T.N.A. Appeal allowed.

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