Withdrawal from Revaluation Reserve— Effect on ‘book profit’U/s.115jb

1.1 S. 115JB was introduced by the Finance Act,
2000 with effect from A.Y. 2001-02, which, in substance, provides that if the
income-tax payable on Total Income is less than 7.5% of the ‘Book Profit’ of the
Company, then the ‘Book Profit’ shall be deemed to be the Total Income of the
assessee, on which tax is payable @ 7.5% (this rate is subsequently increased
from time to time and presently the same is 18% from A.Y. 2011-12). This
position emerges on account of subsequent amendment made in S. 115JB by the
Finance Act, 2002 with retrospective effect from A.Y. 2001-02. Accordingly, in
such cases, u/s.115JB Minimum Alternative Tax (MAT) is payable by the Company.
S. 115JB is the successor of S. 115JA, which was introduced by the Finance (No.
2) Act, 1996 with effect from 1997-98 and which continued up to A.Y. 2000-01.
Originally, for the purpose of levy of MAT, S. 115J was introduced by the
Finance Act, 1987 with effect from A.Y. 1988-89, which continued up to A.Y.
1990-91.

1.2 Basically, all the abovereferred three
provisions enacted for the purpose of levy of MAT are on similar line with one
major difference that u/s.115JB MAT liability is to be worked out at 7.5% of the
‘Book Profit’ and the ‘Book Profit’ is deemed to be Total Income, whereas in the
earlier provisions, 30% of the ‘Book Profit’ was deemed to be the Total Income
in cases where the Total Income of the Company was found to be less than 30% of
its ‘Book Profit’. This and certain other differences in such provisions are not
relevant for the purpose of this write-up.

1.3 Under all the abovereferred three provisions,
one common thread is that the basis of working of ultimate tax liability is the
‘Book Profit’. In all these provisions, one common provision can be noticed that
the Company shall prepare its Profit & Loss Account for the relevant Previous
Year, in accordance with the provisions of Parts II and III of Schedule VI to
the Companies Act, 1956. In this context, the provisions of S. 115JB have been
made more stringent with which also we are not concerned in this write-up. By
and large, the profit shown in such Profit & Loss Account cannot be disturbed by
the AO in view of the judgment of the Apex Court in the case of Apollo Tyres
Ltd. (255 ITR 273). This judgment we have analysed in this column in the June,
2002 issue of this Journal.

1.4 In all the abovereferred three Sections, the
‘Book Profit’ is defined in the relevant Section. In such definition, starting
point, in each of the Section, is net profit means ‘Net Profit as shown in the
Profit & Loss Account for the relevant Previous Year’ and the definition further
specifies certain items for adjustments to increase such net profit
(‘Specified Items for Upward Adjustments’) and items for adjustments to
reduce the net profit so increased, (‘Specified Item for Downward
Adjustments’) as provided therein. One such ‘Specified Item for Downward
Adjustment’ provided in all the three provisions relates to the amount withdrawn
from any Reserve or Provision, if any such amount is credited to the Profit &
Loss Account. In S. 115JB, ‘Book Profit’ is defined in Explanation 1 to S. 115JB
(the said Explanation). In the said definition, the ‘Specified Item for
Downward Adjustment’ relating to such withdrawal from Reserve/Provision
appearing in clause (i) reads as under :

1.5 In cases where the Company revalues its Fixed
Asset resulting into increase in the value of such assets in the books of the
Company, the increased amount is credited to Revaluation Reserve Account in
accordance with the accepted accounting principles. In view of such revaluation,
the Company is required to provide depreciation on fixed assets on the revalued
amount of such assets instead of on the basis of historical costs. At the same
time, the Company is permitted to withdraw from the Revaluation Reserve Account
differential amount of depreciation (i.e., the amount of depreciation
related to revalued amount of fixed assets). In such cases, effectively, the
amount of charge of depreciation to Profit & Loss Account equals to the
depreciation, which would have been otherwise charged on historical cost. This
is accepted accounting practice.

1.6 In the past, the issue was under debate as to whether in such cases, the amount withdrawn from Revaluation Reserve Account should be reduced from the net profit for the purpose of computing the ‘Book Profit’ by treating the same as item of “Exclusion from the ‘Book Profit’ ’’ as provided in the said Clause (i) or the same should not be so excluded as it falls in the category of “Restriction on Exclusion from the ‘Book Profit’ ’’. The Delhi High Court in the case of Indo Rama Synthetics (I) Ltd. (184 Taxman 375) has decided the issue against the assessee. However, some of the professionals still held the view that such withdrawal from the Revaluation Reserve Account should be treated as item of “Exclusion from the ‘Book Profit’ ’’, mainly on the ground that at the time of creation of Revaluation Reserve, as per the accepted accounting principles and practices, the amount of revaluation was never required to be routed through Profit & Loss Account and hence, the restriction contained in the Proviso to the said Clause (i) should not apply.

1.7 It may be noted that by virtue of the amendment made by the Finance Act, 2006 with effect from A.Y. 2007-08, a specific provisions are made in the definition of ‘Book Profit’ in S. 115JB because of which, effectively, depreciation relating revalued amount is required to be ignored.

1.8 Recently, the Apex Court had an occasion to consider the abovereferred judgment of the Delhi High Court in the case of Indo Rama Synthetics (I) Ltd. and the issue has now got settled. Though, now there is a specific provision in S. 115JB referred to in para 1.7 above, this judgment will be relevant for pending cases as well as for general principles in the context of the computation of ‘Book Profit’. Therefore, it is thought fit to consider the same in this column.

Indo Rama Synthetics (I) Ltd. v. CIT (unreported):

2.1 In the above case, the brief facts were : during the previous year ending 31-3-2000 (A.Y. 2000-01), the Company had revalued its fixed assets resulting into increase in book value of such assets by Rs.288.58 cr. During the previous year relevant to A.Y. 2001-02, in the Profit & Loss Account, a charge of depreciation was shown at Rs.127.57 cr. which was reduced by the transfer from Revaluation Reserve Account to the extent of Rs.26.12 cr. resulting in a net debit on account of depreciation at Rs.101.45 cr. The net profit as per Profit & Loss Account of the Company was Rs.18.74 cr. In the return of income, while computing ‘Book Profit’ for the purpose of MAT liability u/s.115JB, the asses-see treated the amount of Rs.26.12 cr. withdrawn from the Revaluation Reserve Account as item of “Exclusion from the ‘Book Profit’ ’’ under the said Clause (i) and accordingly, reduced the amount of profit by that amount. During the assessment proceedings, the Assessing Officer (AO) disallowed the claim of such reduction of Rs.26.12 cr. while computing the ‘Book Profit’ on the ground that the Revaluation Reserve Account was created in the A.Y. 2000-01 and this amount was not added back to the net profit for the purpose of computing the ‘Book Profit’ as provided in the said proviso to the said Clause (i) and accordingly, this amount falls in the category of “Restriction on Exclusion from the ‘Book Profit’ ’’. The assessee did not succeed in his appeals before the first Appellate Authority, ITAT as well as the High Court. Accordingly, at the instances of assessee, the issue referred to in para 1.6 above came up for consideration before the Apex Court.

2.2 Before the Apex Court, on behalf of the assessee, it was, inter alia, contended that the creation of Revaluation Reserve does not impact the Profit and Loss Account in the year of creation; such Revaluation Reserve is not a free reserve; the same is not available for distribution of profits; unlike revenue reserves, such reserve is not an appropriation of profits and the same is never debited by way of debit entry through Profit & Loss Account; the Revaluation Reserve is in the nature of adjustment entry to balance both the sides of balance sheet, etc. It was further contended that the treatment of Revaluation Reserve is governed by the Accounting Standards 10 and 6 (AS) and the Guidance Note on Treatment of Reserves Created on Revaluation of Fixed Assets (Guidance Note) issued by the Institute of Chartered Accountants of India (ICAI) and on that basis the amount of such reserve is not debited to Profit & Loss account in the year of creation and the amount of revaluation is directly credited to Revaluation Reserve Account. Since in the year of creation of such reserve, the ‘Book Profit’ suffers full tax, without being affected by creation of such reserve, in the year of withdrawal, the amount withdrawn would be liable to be reduced while computing the ‘Book Profit’. It was also pointed out that by virtue of the amendment made by the Finance Act, 2006 (referred to in para 1.7) the deprecation on historical cost would only be taken into account while computing the ‘Book Profit’ and the same is applicable from A.Y. 2007-08.

2.3 After considering the arguments raised on behalf of the assessee, the Apex Court proceeded to decide the issue and for that purpose noted the provisions of S. 115JB. The Court also referred to the historical background of the provisions relating to MAT starting from S. 115J onwards referred to in paras 1.1 and 1.4 above. The Court then stated that even in the S. 115J certain adjustments were required to be made to the net profit as shown in the Profit & Loss Account which included the re-duction of the amount of net profit by the amount withdrawn from any reserve, if any such amount is credited to the Profit & Loss Account. The Court then noted that some companies have taken advantage of this provision u/s.115J by decreasing their net profit by the amount withdrawn from the reserve created in the same year itself, though the reserve when created, had not gone to increase the ‘Book Profit’. According to the Court, such adjustments led to lowering of profits resulting in the reduction of tax liability based on the net profits. In view of this, S. 115J was amended and it was provided that the ‘Book Profit’ will be allowed to be decreased by the amount withdrawn from any reserve only in the following two cases:

“*(i) if such reserve has been created in the pre-vious year relevant to the assessment year commencing w.e.f. 1-4-1998

OR

(ii)    if the reserve so created in the previous year has gone to increase the book profit in any year when S. 115J was applicable.”

*    This should be reserve created prior to the previous year relevant to the assessment year commencing on 1-4-1988.

2.4 The Court further stated that under the ap-plicable provisions, the first step for determining the ‘Book Profit’ is that the net profit as shown in the Profit & Loss Account for the relevant year has to be increased by the items specified [Clauses (a) to (f)] in the definition (if the amount of such item is debited to Profit & Loss Account) which includes [in Clause (b)] the amount carried to any specified reserve by whatever name called. The second step is that the amount so increased has to be reduced by the items specified [Clauses (i) to (vii)] in the definition which includes [in clause (i)] an amount withdrawn from any reserve (with some exception), if any such amount is credited to the Profit & Loss Account. The Court also noted the “Restriction on Exclusion from the ‘Book Profit’ ’’ as provided in the Proviso to the said Clause (i).

2.5 The Court then noted that the following question needs consideration in this case:

“Q.: Could Rs.26,11,74,000, being the differential depreciation recouped from the revaluation reserves created during the earlier A.Y. 2000-01, be said to be credited in the P & L Account during the assessment year in question in terms of clause (i) to the explanation to S. 115JB(2)?”

2.6 Explaining the effect of the definition of ‘Book Profit’, the Court stated that the said Clause (i) mandates reduction for the amount withdrawn from the reserve earlier created if the same is credited to Profit & Loss Account. The said Clause
(i)    contemplates only those reserves which actually affect the net profit as shown in the Profit & Loss Account. The object of providing “Specified Exclusion from the ‘Book Profit’ ” is to find out true working result of the Company.

2.7 Dealing with the case of the assessee, the Court noted that the adjustment made in the Profit & Loss Account by the assessee, is as per AS and the Guidance Note of the ICAI which is in conformity with the provisions of S. 211 of the Companies Act, 1956. The Court also noted that before considering the effect of withdrawal of Rs.26.12 cr. from the Revaluation Reserve, the Company had a loss of Rs.7.38 cr. Accordingly, on account of such withdrawal from the Revaluation Reserve, the said loss has got converted into profit of Rs.18.74 cr. The said adjustment primarily is in the nature of contra adjustment in the Profit & Loss Account and it is not the case of effective credit to the Profit & Loss Account as contemplated in the said Clause (i). Credit in the Profit & Loss Account under the said Clause (i), implies the effective credit and therefore, as per the accounting principles, the contra adjustment does not at all affect any particular account. According to the Court, unless an adjustment has the effect of increasing the net profit as shown in the Profit & Loss Account the amount cannot to be said to be credited to the Profit & Loss Account. Therefore, through the amount has been literally credited to the Profit & Loss Account, in substance, there is no such credit. After taking such a view and con-sidering the object for which the MAT provisions were introduced, the Court held as under:

“….In the present case, had the assessee deducted the full depreciation from the profit before depreciation during the accounting year ending 31-3-2001, it would have shown a loss and in which event it could not have paid the dividends and, therefore, the assessee credited the amount to the extent of the additional depreciation from the revaluation reserve to present a more healthy balance sheet to its shareholders enabling the assessee possibly to pay out a good dividend. It is precisely to tax these kinds of companies that MAT provisions had been introduced. The object of MAT provisions is to bring out the real profit of the companies. The thrust is to find out the real working results of the company. Thus, the reduction sought by the assessee under clause (i) to the explanation to S. 115JB(2) in respect of depreciation has been rightly rejected by the AO.”

2.8 Having taken the above view, the Court further stated that the matter can be examined from another angle under the said Clause (i). The assessee becomes entitled to reduce the amount withdrawn from such reserve only if at the time of creation, the reserve had gone to increase the ‘Book Profit’ u/s.115JB/115JA. From the factual position of the assessee, it is clear that neither the amount of Rs.288.58 cr. nor Rs.26.12 cr. had ever gone to increase the ‘Book Profit’ in the said year ending on 31-3-2000. As such amount has not gone to increase the ‘Book Profit’ at the time of creation of reserve, there is no question of reducing the amount transferred from such reserve to the Profit & Loss Account. Restriction contained in the Proviso comes in the way of such reduction. The Court also stated that by interplay of the balance sheet items with Profit & Loss Account items, the assessee has sought to project the loss of Rs.7.38 cr. as profit of Rs.18.73 cr.

Conclusion:

3.1 From the above judgment of the Apex Court, it is clear that in all such cases of withdrawal of the amounts from Revaluation Reserve, the assessee would not be entitled to reduce such amount under the said Clause (i) for the purpose of computing the ‘Book Profit’.

3.2 The said Clause (i) contemplates that the credit of the amount of such withdrawal to the Profit & Loss Account must be real (and not literal) and the same must in effect impact the net profit shown in the Profit & Loss Account. Under the said Clause (i), such reduction is permissible only in those cases where, at the time of creation of reserve, the ‘Book Profit’ is increased by the amount of the said reserve.

3.3 From the above judgment, it also appears that unless the assessee is in a position to show that at the time of creation of reserve the ‘Book Profit’ was increased by the amount of such reserve, the reduction under the said Clause (i) on account of withdrawal is not permissible and for this purpose, it is not relevant that at the time of creation of reserve the assessee was not required to route the amount of reserve through the Profit &    Loss Account in accordance with the accepted and settled accounting principles and practices.

3.4 The above judgment is delivered in the con-text of the provisions of S. 115JB as applicable to the A.Y. 2001-02. As mentioned in para 1.7 above, the definition of the ‘Book Profit’ in S.

115JB is further amended by the Finance Act, 2006 from the A.Y. 2007-08 and specific provisions are made for adjustments with regard to the amount of depreciation debited to the Profit & Loss Account because of which, effectively, depreciation relating to revalued amount of assets is required to be ignored and the amount withdrawn from the Revaluation Reserve Account relating to such depreciation is required to be separately deducted under clause (iib) of the said Explanation. Therefore, from the A.Y. 2007-08, in such cases, the issue may arise with regard to the treatment of the amount withdrawn in excess of the amount referred to in clause (iib), if any from the Revaluation Reserve Account and credited to the Profit & Loss Account while computing the ‘Book Profit’.

Note : The above judgment is now reported in 330 ITR 363.