Secret reserve treatment: premium and discount account was held includible in capital base under the governing reserve test.

A premium and discount account kept as a secret reserve and omitted from the published balance-sheet can be treated as a reserve for inclusion in capital base if it is specifically appropriated by the competent authority. The governing test is that a reserve must be earmarked as such and not merely represent carried-forward surplus or undistributed profits. In the banking context, the statutory framework recognises reserves that may not appear in the published balance-sheet, and board-level allocation of profits may be sufficient. On the facts, the account reflected a deliberate hidden reserve created by valuation below market value, so the amount was includible in capital base.

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Issues: Whether the amount standing to the credit of the premium and discount account, kept as a secret reserve and not disclosed in the published balance-sheet, was a reserve includible in the capital base under rule 1 of the Second Schedule to the Super Profits Tax Act, 1963.

Analysis: The governing test is that an amount can be treated as a reserve only if it is specifically earmarked or appropriated as such by the authority competent to do so, and it must not merely be a carried-forward surplus or undistributed profit. In the case of banking companies, the statutory scheme under the Banking Regulation Act, 1949 and the Companies Act, 1956 recognises that reserves may exist which are not shown in the published balance-sheet, and the board of directors may have authority to allocate profits to reserve accounts. The account in question was shown in the books as a premium and discount account, represented the difference between market value and book value of investments, and functioned as a hidden reserve created by deliberate valuation below market value. The material supported the conclusion that the amount had been appropriated to reserve by the requisite authority and was not merely an unallocated surplus.

Conclusion: The amount of Rs. 76,58,687 was a reserve and was includible in the assessee's capital base; the answer was in favour of the assessee.

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