Surtax capital computation: excluded income must be matched against total income, and a statutory profit appropriation can qualify as reserve.

For surtax capital computation under the Second Schedule, rule 4 requires capital to be reduced by the proportion of income, profits and gains not includible in total income against the company's total income, profits and gains, rather than by limiting the exercise to Indian income. A statutory appropriation of profits that is not earmarked to meet any specific liability or contingent loss qualifies as a reserve under rule 1. On these principles, the assessee's method of computation was accepted and the Debt Adjustment Fund was treated as part of capital.

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Issues: (i) Whether, for computing capital under rule 4 of the Second Schedule to the Companies (Profits) Surtax Act, 1964, the assessee's capital had to be reduced by applying the ratio of income not includible in total income to the company's total commercial income, or only by reference to Indian income as adopted by the revenue authorities; (ii) Whether the Debt Adjustment Fund created under Swedish company law constituted a reserve for the purpose of capital computation under rule 1 of the Second Schedule.

Issue (i): Whether, for computing capital under rule 4 of the Second Schedule to the Companies (Profits) Surtax Act, 1964, the assessee's capital had to be reduced by applying the ratio of income not includible in total income to the company's total commercial income, or only by reference to Indian income as adopted by the revenue authorities.

Analysis: Rule 4 distinguishes between the company's income, profits and gains on the one hand and its total income on the other. Where part of the company's income, profits and gains is not includible in total income, capital is to be diminished by the proportion which the excluded amount bears to the company's total income, profits and gains. The exclusion may arise under section 5(2) in the case of a non-resident, or under section 10 in other cases. The rule does not warrant first restricting the exercise to Indian income and then identifying excluded items within that narrower base. The return form and its explanatory note supported the assessee's construction.

Conclusion: The assessee's method of computation was correct and the revenue authorities' interpretation was erroneous. This issue was decided in favour of the assessee.

Issue (ii): Whether the Debt Adjustment Fund constituted a reserve for the purpose of capital computation under rule 1 of the Second Schedule.

Analysis: The fund was required by Swedish company law as an allocation from profits and was not shown to be created for meeting any specific liability or contingent loss. A statutory appropriation of profits of this nature answers the description of a reserve and therefore forms part of capital under rule 1. The conclusion was supported by the principle that amounts set apart out of profits, not earmarked for a known liability, may be treated as reserve.

Conclusion: The Debt Adjustment Fund was a reserve and had to be included in capital. This issue was decided in favour of the assessee and against the revenue.

Final Conclusion: The assessee's appeal succeeded and the revenue's appeal failed, leaving the assessee entitled to the favourable capital computation and the inclusion of the Debt Adjustment Fund in capital.

Ratio Decidendi: For surtax computation, rule 4 of the Second Schedule requires reduction of capital by reference to the proportion of income, profits and gains not includible in total income against the company's total income, profits and gains, and a statutory appropriation of profits not earmarked for a specific liability constitutes a reserve.

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