COMMISSIONER OF INCOME-TAX (CENTRAL ZONE), KARACHI Versus MESSRS BEACH LUXURY HOTEL LIMITED
1. AJMAL MIAN, J .---These are four applications under section 66(2) of the Income-tax Act, 1922, hereinafter referred to as the Act, pertaining to the Assessment Years 1967-68, 1968-69, 1969-70 and 1970-71, whereby the applicant solicits the opinion of this Court on common question of law. It will suffice to reproduce the question from one of the above references. The only variation is that the amount is different in each of the above references. The question referred to in I.T.R. No. 29 of 1976 reads as follows:
2. "Whether on the facts and in the circumstances of the case, the Income-tax Appellate Tribunal was justified in holding that the sum of Rs.38,12,251 does not form a part of 'free reserves' and consequently does not fall within the purview of Explanation 5 to Subsection (1) of section 4 of Income-Tax Act."
2. The brief facts leading to the filing of the above references are that the respondent-assessee purchased for a sum of Rs.1,21,00,000 erstwhile Nedus Hotel (hereinafter referred to as the Hotel), an evacuee property from the Settlement Department. Instead of making payment in cash it purchased the deferred amount to the extent of the above purchase price from various compensation books for a sum of Rs.56,76,189 and thus saved a sum of Rs.64,23,811, which was transferred to a capital reserve account. The Income-tax Officer treated the above sum as a free reserve, particularly on account of the fact that in one of the years the respondent had declared bonus shares of the value of Rs.1,00,000 out of the aforesaid reserve. The Income-tax Officer treating the above sum as a free reserve, computed the available taxable free reserve for all the above years and brought the same to the charge of tax. In the aforesaid process he also sought for the year 1967--68 to set off the business loss against the above free reserve. The respondent being aggrieved by the above orders of the Income-tax Officer filed four Appeals, namely:
3. I.T.A. No. 75/KB of 1972-73 (Assessment year 1967-68).
4. I.T.A. No. 1818/KB of 1972-73 (Assessment year 1968-69).
5. I.T.A. No. 1820/KB of 1972-73 (Assessment year 1969-70).
6. I.T.A. No. 1233/K B of 1973-74 (Assessment year 1970-71).
7. The learned Income-tax Appellate Tribunal by a detailed order, dated 17-6-1974 accepted the above appeals and held that the action of the Income-tax Officer in treating fictitious surplus as a reserve in the first instance and as a free reserve in the second instances cannot be sustained. The applicants filed applications before the learned Income-tax Appellate Tribunal under section 66(1) of the Act for getting the above questions referred to this Court for its opinion but the above applications were declined by the learned Tribunal by its order, dated 24-11-1975. The applicants have, therefore, fired the present applications under section 66(2) of the Act
3. In support of the above references Mr. Nasrullah Awan learned counsel for the applicant has vehemently urged that the respondent instead of paying sum of Rs.1,21,00,000 as the price of the Hotel in cash, paid the same through the compensation books which cost their: only Rs.56,76,189 and, therefore, the respondent saved a sum of Rs.64,23,811 which was in fact free reserve as was treated by the Income-tax Officer.
8. On the other hand Mr. Ali Athar learned counsel for the respondent has submitted that in fact there was no real gain nor it could be treated as realised capital gain but it was merely book entry to balance the entry of the purchase price. He has referred to the case of Commissioner of Income-tax (Central) v. Beach Luxury Hotel Ltd. 1983 P T D 178 (H.C. Kar), in which it was held, by a Division Bench of this Court upon a reference that the surplus arising from the difference in the face and purchase prices of compensation books and credited to the capital reserve account in balance-sheet, was not an income subject to tax. It may be stated that in the above case the subject-matter in question was the subject-matter of the present references but with reference to sections 2(4-A) and 10 of the Act and the question referred to was as follows:
9. "Whether on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that the net surplus of Rs.16,74,788 arising from the difference in the face and purchase prices of compensation books and credited to the capital reserve account in balance-sheet was not chargeable to tax?"
10. The above question was answered by a Division Bench of this Court in the affirmative. It has been submitted by Mr. Ali Athar that the above judgment lends support to the conclusion arrived at by the learned Income-tax Appellate Tribunal as the entry in the capital reserve of the above difference was merely fictional and not real. It may be observed that the learned Income-tax Appellate Tribunal has dilated upon the question in issue thoroughly. The operative portion of the order reads as follows:
11. "After considering these facts we are of the opinion that on the admitted facts in this case, surplus taken to the capital gains account was nothing but a fictional entry. Admittedly the appellant had not realised any real gain as none in such a transaction can be realised. It is the purchase and sale of an asset that can create the real income of .a loss but mere book entries do not generate gains incomes or losses. There are copious judicial pronouncements, which settle the proposition that the tax is to be levied on real incomes and such real A incomes cannot be generated by mere book entries. For example, if a lac of rupees is in my pocket and I conceive in my mind that this would become double if devaluation takes place I would not be able to generate the income of one lac just by recording these two transactions in my books. Fiction cannot take the place of reality unless the law so desires. In the present case the appellant rightly contends that there being in fact no reserves within the definition of this term as commonly understood or as technically defined, the question of the creation of Free Reserve would not arise at all. We agree that a reserve owes its creation or existence to some available real profits. In the present case there were no real available profits at all as the appellant had not gained anything but had made the necessary entries in the books of accounts only to balance the same, because of the fact that for a much larger acquisition, it had to make for similar payments. Since the accounting compelled the appellant to take recourse to create a fictional entry in order to balance the two recorded transactions, the Capital Gains Reserves account was, of course, created. There was no profit or any realised gain available, to the appellant to create any reserve out of the same. Therefore, if no reserve could be created as such, for the question of the creation of a Free Reserves or any kind of Reserve could automatically not arise. The action of the Income-tax Officer, therefore, in treating this fictitious surplus as a reserve in the first instance, and as a Free Reserve in the second instance, cannot be sustained. On this issue, therefore, the appellant must succeed.
4. We are also inclined to concur with the above reasoning of the learned Income-tax Appellate Tribunal that fiction cannot take the place of reality unless the law so provides expressly and that as the above difference was neither a profit nor any realised gain, therefore it could not have been treated as a reserve or a free reserve. We are of the view that it was merely a book entry in the capital) reserve account for the purpose of balancing the entry of the purchase price namely Rs.1,21,000.
12. Mr. Nasarullah Awan has referred to S.R.O. 116(R)/68, dated 1-7-1968 which was issued in exercise of the powers conferred by clause (6-BB) of section 2 of the Act and whereby reserves of a company were defined.
13. The above S.R.O. reads as follows:-
14. "S.R.O. 116(R)/68, dated 1-7-1968.--In exercise of the powers conferred by clause (6-BB) of section 2 of the Income-tax Act, 1922 (XI of 1922), the Central Board of Revenue is pleased to declare all the reserves of a company other than the following to be the free reserves of the company, namely:-
(i) Reserves created as a result of re-valuation of fixed assets.
(ii) Goodwill Reserve.
(iii) Depreciation reserve to the extent of ordinary depreciation including allowance for extra shifts admissible under the aforesaid Act and the Rules made thereunder.
(iv) Development Allowance Reserve created under clause (vi-a) of subsection (2) of section 10 of the aforesaid Act.
(v) Workers Welfare Fund.
(vi) Reserve for Taxation to the extent of the current liability of the company."
15. It has been contended by Mr. Nasrullah Awan that in view of the above S.R.O. the Income-tax Officer had correctly treated the above capital reserve entry as a reserve as the same does not fall in any of the above clauses; whereas Mr. Ali Athar has relied upon clause (i).
16. It may be observed that factually there was no material before the learned Income-tax Officer to conclude that if the price of the hotel was to be paid in cash and not through the compensation book which was permissible, the respondent would have purchased the, hotel for the same price, nor was there any material to indicate that factually the hotel was of the value equivalent to the price. As observed hereinabove that transfer of the difference in the price it the capital reserve by making an entry was merely a fictional entry on paper and not in reality, it may be said that though the actual price of the hotel was Rs.56,76,189 and not Rs.1,21,000 but because of the debit entry of the above price the above entry was to be balanced by making the above entry in the capital reserve. The contention of Mr. Ali Athar that the instant case was under clause (i) of the above-quoted S.R.O. has force.
5. For the aforesaid reasons, our answer to the above question is in the affirmative. These are the reasons in pursuance of a short order of even date. The references stand disposed of in the above terms with no order as to costs.
17. M.B.A./C-36/K Answered in affirmative.