Reserve must exist on the first day of the chargeable period; later appropriation cannot be related back for capital computation.

For computing capital under rule 2(1) of Schedule II to the Business Profits Tax Act, only amounts actually and validly appropriated as reserves by the competent authority on or before the first day of the chargeable accounting period could be included. Amounts set apart before 1 April 1946 included Rs. 11,00,000 and Rs. 9,00,000 for tax liabilities, both treated as reserves because they had been validly earmarked; Rs. 2,73,504 remaining in profit and loss account was only undistributed profit and did not qualify. For the later period beginning 1 January 1947, a reserve created only on 15 April 1947 could not be related back to the earlier date, so Rs. 5,25,000 was excluded from capital.

---

---

Issues: (i) Whether the amounts set apart from profits for reserve and for tax liabilities formed part of the company's capital as reserves for the chargeable accounting period commencing on 1 April 1946. (ii) Whether the amount allocated out of profits for the later chargeable accounting period commencing on 1 January 1947 was validly and effectively appropriated as reserve before the relevant date.

Issue (i): Whether the amounts set apart from profits for reserve and for tax liabilities formed part of the company's capital as reserves for the chargeable accounting period commencing on 1 April 1946.

Analysis: Under rule 2(1) of Schedule II read with section 2(1)(a) of the Business Profits Tax Act, 1947, the capital of the company had to be computed as on the first day of the chargeable accounting period, and only amounts which had been actually and validly appropriated as reserves by a person having the requisite authority could be treated as reserve. The directors, who alone had authority under the Companies Act and the articles, had already resolved before 1 April 1946 to set apart Rs. 11,00,000, and that allocation was complete on the material date. The amount of Rs. 2,73,504 standing in the profit and loss account was merely undistributed profit and not an existing reserve. The sum of Rs. 9,00,000 set apart for tax liabilities was also treated as a reserve because it had been validly earmarked for a specific purpose and retained for use in that way.

Conclusion: The amount of Rs. 11,00,000 formed part of the company's capital as reserve for the first chargeable accounting period, the amount of Rs. 9,00,000 also qualified as reserve, and the amount of Rs. 2,73,504 did not qualify as reserve.

Issue (ii): Whether the amount allocated out of profits for the later chargeable accounting period commencing on 1 January 1947 was validly and effectively appropriated as reserve before the relevant date.

Analysis: For the later period, the relevant date was 1 January 1947. Although the directors had authority to make the allocation, they did so only on 15 April 1947, after the material date. Since reserve must exist in fact on the first day of the chargeable accounting period, the later appropriation could not be related back to 31 December 1946 merely because it was so shown in the balance sheet.

Conclusion: The amount of Rs. 5,25,000 was not validly and effectively allocated as reserve before 1 January 1947 and could not be included in the company's capital for the second chargeable accounting period.

Final Conclusion: The reference succeeded in part for the first period and failed for the second period, with only the reserve actually and validly created before the relevant date being includible in capital.

Ratio Decidendi: For computing capital under rule 2(1) of Schedule II to the Business Profits Tax Act, only a profit allocation actually and validly made by the competent authority on or before the first day of the chargeable accounting period can be treated as reserve, and a sum earmarked for tax liabilities may also qualify if so validly appropriated.

---