Commercial substance test determines whether dividend reserve counts as capital for surtax computation, excluding dividend earmark.

For surtax capital computation under rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964, the character of an amount placed in a dividend reserve depends on its commercial substance on the relevant date. Amounts appropriated from profits and shown under reserves and surplus may count as reserve, but the portion earmarked to meet a recommended dividend is not reserve capital. On the facts, the aggregate dividend reserve of Rs. 5,90,000 had to be reduced by the dividend provision of Rs. 2,30,000, leaving Rs. 3,60,000 as the includible reserve.

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Issues: (i) Whether the dividend reserve was a reserve includible in the computation of capital under rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964; (ii) if so, whether the includible amount as on 1 July 1964 was Rs. 5,90,000 or Rs. 3,60,000.

Issue (i): Whether the dividend reserve was a reserve includible in the computation of capital under rule 1 of the Second Schedule to the Companies (Profits) Surtax Act, 1964.

Analysis: The classification of the amount had to be judged on a commercial and substantive basis. The amount credited to the dividend reserve had been appropriated from profits and stood in the balance-sheet under reserves and surplus. The fact that a portion of the reserve was intended to meet a recommended dividend did not convert the entire amount into a liability. The amount earmarked for dividend could not be treated as a reserve, but the balance remaining in the account retained the character of reserve.

Conclusion: The question was answered in the affirmative in principle, but only the amount properly retained as reserve was includible in capital.

Issue (ii): If so, whether the includible amount as on 1 July 1964 was Rs. 5,90,000 or Rs. 3,60,000.

Analysis: The reserve account showed Rs. 5,90,000 in aggregate, but Rs. 2,30,000 had been recommended for dividend and was to be met from the current appropriation. On a commonsense commercial view, that amount could not remain part of the capital reserve available for surtax computation. The balance after meeting the proposed dividend was Rs. 3,60,000, and only that balance remained as reserve on the relevant date.

Conclusion: The includible amount was Rs. 3,60,000.

Final Conclusion: The reference was answered by treating only the balance remaining after provision for the proposed dividend as reserve for surtax capital computation.

Ratio Decidendi: For surtax purposes, the character of an amount credited to reserve must be determined on its commercial substance on the relevant date, and amounts effectively appropriated for dividend payment cannot be treated as reserve capital.

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