Earned surplus credited to reserves retains reserve character when the allocation is effective and complete under surtax rules.

Earned surplus credited in the assessee's books was treated as a reserve where the amounts were specifically set apart for future business use and were not merely unallocated profits. The Explanation to rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964 was read as excluding only proposed or unfinalised allocations, not effective and complete transfers already made to the earned surplus account. On that basis, the credited balance retained the character of reserves and was included in the reserve base for surtax purposes, in favour of the assessee.

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Issues: Whether the balance to the credit of the earned surplus accounts in the books of the assessee as on the first day of the relevant previous year, or any part of it, constituted reserves within the meaning of rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964, read with the Explanation thereto.

Analysis: The accounting treatment of earned surplus had already been recognised in earlier decisions as representing an amount specifically kept apart for future business use and, in the case of foreign companies following a different accounting system, not as mere unallocated profits. The Explanation to rule 1 was understood as excluding only allocations that were not finalised or had not received the necessary approval, such as proposed additions to reserves. On the facts found, the additions to the earned surplus account were effective and complete allocations and not merely proposed entries. The Explanation did not alter the legal position that such credited amounts retained the character of reserves.

Conclusion: The earned surplus balance was rightly treated as part of the reserves, and the question was answered in the affirmative, against the department and in favour of the assessee.

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