J.K. INDUSTRIES LTD. & ANR. v. UNION OF INDIA AND ORS.

f t J.K. INDUSTRIES LTD. v. UNION OF INDIA 297 [KAPADIA, J.] accounting purposes exceeds the amount of depreciation allowed A for tax purposes by Rs.50,000 each year. Accordingly, deferred tax liability is reduced by Rs.20,000 each in both the years. As may be seen, tax expense is based on the accounting income of each period. B In 20xl, the profit and loss account is debited and deferred tax liability account is credited with the amount of tax on the originating timing difference ofRs.1,00,000 while in each of the following two years, deferred tax liability account is debited and profit and loss account is credited with the amount of tax on the reversing timing difference ofRs.50,000. C

Illustration-2 (Application of "Fair Value Principles")

123. A convertible debenture is normally presented in the financial statements as a liability, while it has two components; a liability and an '· D option to convert loan into equity. Appropriate accounting principle requires separate accounting for rights and obligations. Each component has to be separately accounted for. In the past, many of those rights and obligations were shown as off-balance-sheet items. Only recently, on account of accounting standards, the number of such items stand reduced. The issuer of a financial instrument is required to classify convertible E debentures (financial instrument) as liability or as equity depending on the terms of the contract. A convertible debenture is a compound instrument. In case of such instrument, having different components, one has to present such components in financial statements either as equity or as liability based on the terms of the contract. As a general principle, a F contract that will be settled by an entity receiving a fixed number of its own shares is an equity instrument. For example, when an enterprise issues shares in consideration of cash or some other asset/service, the transaction does not result in any cash outflow. For example, a redeemable preference share should be classified as liability and not as equity because it gives G rise to an obligation to deliver cash. This example is given to show that DTL is a liability because it results in cash outflow in future on account of tin1ing differences.

124. A company has an option to designate a financial asset at fair H

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A value through profit or loss. A financial asset held for trading should be classified as an asset at fair value through profit or loss. The difference in the fair value of financial asset at the beginning of the period and at the end of the period is generally recognized as profit or loss in the P&L a/ c. Similarly, loans and receivables are carried at amortized cost unless B the company intends to sell the same immediately. Similarly, there are certain assets like Held-to-maturity-investments which are required to be carried in the balance-sheet at the amortized cost. In all such cases, the company will now have to classify such assets or liabilities at fair value through profit or loss. Therefore, fair value under the new A.S. has c become the basis for measurement of financial assets. Application of new standards will require a change in the mind-set. At present, non-financial companies carry current investments at cost or market value, whichever is lower. However, they carry long term investments at cost. They provide for permanent diminution in value oflong term investment.

D 125. Similarly, in case the company pays customs duty under section 43B of Rs. 100. For tax purpose, that company is entitled to deduction of Rs. I001- in the year it makes payment. But for accounting purpose, it can divide Rs. 100/- into Rs. 80/- +Rs. 20/- (embedded in the closing stock). The company can show Rs. 20/- as pre-paid expense, in the balance-sheet.

126. The above examples indicate that measurement and recognition of timing differences and financial instruments at fair value brings transparency in presentation of financial statements. Lastly, valuation is an important element of the Method of Accounting.

127. In our view, para 9 of AS 22 merely represents gap-filling exercise. therefore. there is no merit in the contention advanced on behalf of the appellants that AS 22 is inconsistent with the provisions of the Companies Act including Schedule VI. It proceeds on the principle that every transaction has a tax effect. The words "true and fair" view in section 211 (1 ) connotes the widest law making powers and, in that context. we hold that that impugned Rule adopting AS 22 is intra vires as the said Rule is incidental and/or supplementary to the specific powers given to the Central Government to make Rules, particularly when such power is given to fill-in details. The word "supplementary" means

J.K. INDUSTRIES LTD. v. UNION OF INDIA 299

[KAPADIA, J.] something added to what is there in the Act, to fill-in details for which the Act itself does not provide. It is something in the sense that is required to implement what is there in the Act. [See Daymond v. South West Water Authority, (1976) 1 All ER 39]. There is no merit in the contention advanced on behalf of the appellants that the impugned Rule seeks to modify the essential features of the Companies Act. Rules made on B • \ matters permitted by the Act to supplement the Act cannot be held to be in violation of the Act. [See Britnell v. Secretary ofState (supra)]. When the power to make rules is limited to particular topics and if that rule falls within the ambit of that topic, namely, taxes on income in the present case, it cannot be said that the rule is inconsistent with the provisions of the c Act. As stated above, the Act and the Rules form part of the composite scheme. The provisions of sections 205, 209 and 211 can be put into operation only if the Act and the Rules are read together. In the present case, in our view, the impugned Rule constitutes a legitimate aid to '· construction of the provisions of the Companies Act. Further, as stated D above, the Central Government is the rule making authority under section 211 (3C). As rule making authority, the Central Government is empowered to enact accounting standards in consultation with NAC which may be at variance with the Standards issued by the Institute.

128. In the case of Union of India and Anr. v. Cynamide India E Ltd. and Anr., reported in [1987] 2 SCC 720 one of the arguments advanced on behalf of the company was that, in calculating the "net worth" the cost of works·· in-progress and the amount invested outside business were excluded from "free reserves" and that such exclusion could not be justified on any known principle of commercial accountancy (See para F 33). The matter related to price fixation. In the Control Order vide para 2(g) the word "free reserve" was defined. Similarly, in the Form prescribed in the Fourth Schedule, several items like bonus, bad debts and provisions, loss/gain on sale of assets etc. were required to be excluded from the cost of production. Therefore, it was argued that such exclusion G was not warranted by principles of commercial accountancy. This argument was rejected by this Court on the ground that it was open to the subordinate body to prescribe and adopt its own mode of ascertaining the cost of production. That the said body was under no obligation to adopt the method indicated under the Income tax Act in allowing expenses H

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A for the purposes of ascertaining income. It was further held that so long as the method prescribed and adopted by the subordinate legislating body is not opposite to the principle statutory provisions and so long as the method prescribed is ancillary to the provisions of the parent Act, it cannot be legitimately questioned. In the present case, as stated above, measurement and recognition methods are not the items under the Companies Act. Methods of recognition and measurements are talked about by the provisions of the Companies Act. Recognition and measurement of various items of revenue expenses etc. stand covered only by the accounting standards. Therefore, it cannot be said that the said standards are contrary to the provisions of the Companies Act. We also do not find any merit in the argument advanced on behalf of the appellants that the impugned Rule does not touch upon maintenance of books of accounts to be kept by the company. Under section 209(3)(b) every company is required to keep its books of accounts on accrual basis and according to double-entry system of accounting. Under section 209(3)(a) every company is required to maintain books of accounts necessary to provide a true and fair view of the state of affairs of the company and its accounts. In our view, books of accounts do not include balance-sheet and P&L ale. However. as stated above, there is a difference between E "true and correct" accrual and "true and fair" accrual. In the past, what prevailed was true and correct accrual. At that time, it was noticed in several cases that profits were overstated and, therefore, the Legislature inserted what is called as "true and fair" accrual concept. The said concept is wider than the concept of true and correct accrual. When section F 209(3) refers lo mainlenance of books of accounts on accrual basis it means ·'true andfi1ir ''accrual. \Vhich would include not only matching principles but also fair valuation principles. These principles do not contravene accrual system of accounting. Moreover, we are concerned with presentation of balance-sheet and P&L ale. These are financial G statements. An investor, shareholder or stake-holder is entitled to know the real income which the company has earned during the year. Provision for diminution in value of an asset results in emergence ofliability. In the past, when timing difference concept was not there, in many cases, profits were overstated, particularly because provision for DTL (deferred ta"Xation) was not recognized. With the introduction of the timing difference H

JX. INDUSTRIES LTD. v. UNION OF INDIA 301

[KAPADIA,J.] concept, it cannot be said that the accrual system of accounting is violated. A As stated above, it is the concept of "timing difference" which obliterates the difference between accounting and tax incomes. Ultimately, the object is to obliterate the difference between accounting income and taxable income. Accounting income is the real income, therefore, in our view, para 9 of AS 22 is not inconsistent with the provisions of the Companies Act, B including Schedule VI.

129. In the case of Bharat Hari Singhania and Ors. v. Commissioner of Wealth-tax (Central) and Ors., reported in AIR (1994) SC 1355 valuation of unquoted equity shares based on the break- up method was challenged. That challenge was rejected on the ground that the break-up method leads to appropriate market value and, therefore, the said method adopted by Rule 1-D of Wealth-tax Rules was neither ultra vires nor inconsistent with section 7 of the Wealth tax Act. We quote hereinbelow paras 13, 14 and 21 of the said judgment which held that it is always open to the rule-making authority to prescribe an appropriate method of valuation out of several methods of valuing an asset. And since the break-up method adopted by the rule-making authority was a known method in the relevant circles, it cannot be said that the method adopted was an impe1missible method. Paras 13, 14 and 21 read as under: E "13. We may first take up the question whether Rule 1-D is void for being inconsistent with the Act or for the reason that it is beyond the rule-making authority conferred by the Act. Section 7(1) indeed defines the expression "value of an asset." It is "the price which in the opinion of the Wealth Tax Officer it would fetch if sold in the open market on the valuation date", but this is made expressly subject to the Rule made in that behalf No. guidance is furnished by the Act to the rule-making authority except to say that the Rule made must lead to ascertainment of the value of the asset (unquoted equity share) as defined in Section 7. It is thus left to the rule-making authority to prescribe an appropriate method for the purpose. Now, there may be several method of valuing an asset or for that method an unquoted equity share. The rule-making authority cannot obviously prescribe all of them together. It has to choose one of them which according to it is more appropriate. The H

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A rule-making authority has in this case chosen the break-up method, which is undoubtedly one of the recognised methods of valuing unquoted equity shares. Even if it is assumed that there was another method available which was more appropriate, still the method chosen cannot be faulted so long as the method chosen is one of B the recognised methods, though less popular. One probable reason why yield method or dividend method was not adopted in the case of unquoted equity shares was that bulk of these companies are private limited companies where the divided declared does not represent the correct state of affairs and to estimate the probable c yield is no simple exercise. The dividends in these companies is declared to suit the purposes of the persons controlling the companies. Maintainable profits rather than the dividends declared represent the correct index of the value of their shares. The break- up method based upon the balance-sheet of the company, D incorporated in Rule 1-D, is a fairly simple one. Indeed, no serious objection can also be taken to this course since the basis of the Rule is the balance-sheet of the company prepared by the company itself - subject, of course, to certain modifications provided in Explanation-II.

E 14. We are not satisfied that the break-up method adopted by Rule 1-D does not lead to proper determination of the market value of the unquoted shares. The argument to this effect, advanced by the learned Counsel for the assessees, is based upon the assumption/ premise that the value determined by applying the yield method is the correct market value. We do not see any basis for this assumption. No empirical data is placed before us in support of this submission or assumption. It may be more advantageous to the assessees but that is not saying the same thing that it alone represents the true market value. It cannot be stated as a principle that only the method that leads to lesser value is the correct method. The idea is to find out the true market value and not the value more favourable to the assessee. Accordingly. the contention that rule 1-D is inconsistent with Section 7(1) or that it travels beyond that purview of Section 7 is rejected. H

J.K. INDUSTRIES LTD. v. UNION OF INDIA 303

[KAPADIA, J.] xxx A

21. The statement of law in the decision would thus establish that it does not purport to "lay down any hard and fast rule." It recognises that various factors in each case will have to be taken into account to determine the method of valuation to be applied in that case. The dividend yield method is not the only method indicated in the case of a going concern; there is the 'earning method' and then a combination of both methods. The several qualifications added to the above rules, as already stated, make them highly cumbersome and time-consuming. The Wealth Tax Officer has to examine the facts and circumstances of each case including the nature of the business, prospects of profitability and similar other considerations before finally determining whether to apply the dividend method, yield method or whether the break- up method should be followed. There may be cases where an assessee may be holding shares of a large number of private companies or other public limited companies whose shares are not quoted. Compared to them, the break-up method incorporated in Rule 1-D is far simpler and far less time-consuming. It prescribes a simple uniform method to be followed in all cases. All that the Wealth Tax Officer has to do is to take the balance-sheet, delete some items from the columns relating to assets and liabilities as directed by Explanation-II, and then apply the formula contained in the Rule. He need not have to look into the profitability, the earning capacity and the various other factors mentioned in propositions (2), (3) and (4) of the decision. The decision, it bears repetition, recognises that break-up method "nonetheless is one of the methods." In the circumstances, it is difficult to agree with the learned Counsel for the assessees either that break-up method is not a recognised method or that yield method is the only permissible method for valuing the unquoted equity shares. It is not as if the rule-making authority has adopted a method unknown in the relevant circles or has devised an impermissible method. There is no empirical data produced before us to show that break- up method does not lead to the determination of market value of the shares. Merely because yield method may be more H

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A advantageous from the assessee's point of view, it does not follow that it alone leads to the ascertainment of true market value and that all other methods are erroneous or misleading. This aspect we have emphasised hereinbefore too."

Validity of Para 33 of AS 22 B

130. We have already quoted hereinabove para 33. The said para is challenged on the ground that a subordinate legislation cannot be retrospective unless there is provision to that effect in the parent Act. Therefore, the short question which we have to decide is whether the said para is retrospective.

131. To decide the said question, we have to analyse the scope of para 33. For the purpose of detennining accumulated deferred tax in the period in which the Standard is applied for the first time, the opening balances of assets and liabilities for accounting purposes and for tax purposes are to be compared and the differences, if any, are to be detennined. The tax effect ofthese differences have got to be recognized as OTA or DTL, if such differences are timing differences. For example, in the year in which a company adopts AS 22, the opening balance of a fixed asset is, let's say, Rs. 100 for accounting purposes and Rs. 60 for tax purposes. This difference is because the company applied written down value method of depreciation for calculating taxable income, whereas for calculating accounting income it adopts straight-line method. This difference will reverse in future when depreciation for tax purposes will be allowed as compared to depreciation for accounting purposes. In this example, let's assume that the tax rate is 40 per cent and that there are no other timing differences then, DTL would be [Rs. l 00\- Rs. 60] x 40/ 100 =Rs. 16

132. Once we are required to take into account the concept of opening balance of a fixed asset in para 33, it cannot be said that the said para is retrospective. In fact, it is a transitional provision. Let's say that there is an expenditure which is written off for accounting purposes in the year in which it is incurred but is admissible for deduction under Income~tax Act over a period of time. In such a case, the asset representing expenditure would have a Balance only for tax purposes and

J.K. INDUSTRIES LTD. v. UNION OF INDIA 305

[KAPADIA,J.] not for accounting purposes. Therefore, the difference between the Balance A of the asset for tax purposes and balance for accounting purposes, which is nil, would give rise to a timing difference which will reverse in future when expenditure would be allowed for tax purposes. In such a case, OTA would be recognized in respect of difference, subject to the principle of prudence. In the circumstances, it cannot be said that para 33 is retrospective. Conclusion:

133. For the aforestated reasons, we are of the view that the impugned Notification/Rule is neither ultra vires nor inconsistent with the provisions of the Companies Act, including Schedule VI.

134. To sum up, deferred tax is nothing but accrual of tax due to divergence between accounting profit and tax profit. This difference arises on two counts, namely, different treatment of items of revenue/expense as per profit and loss account and as per the tax law. It also arises on account of the difference between the amount of revenue/expense as per profit and loss account and the coITesponding amount considered for tax purposes, e.g., depreciation.

135. However, we need to comment on one aspect. Before the E Calcutta High Court, the impugned Notification adopting AS 22 was also challenged on the ground that the provisions of AS 22 insofar as it relate to ' 'deferred taxation' ' is violative of Articles 14 and 19( 1)(g) of the Constitution oflndia. In this connection, it was pleaded that by making AS 22 mandatory, the appellants' companies will suffer erosion ofits net F worth. That, as a result, the debt equity ratio will also increase and that the lenders may recall the loans and thereby the appellants' rights to carry on business in future would be violated. Although, the aforestated challenge was pleaded in the writ petition, when the matter can1e for hearing before the High Com1, it appears that the said grounds were not argued. G According to the appellants, implementation of AS 22 would result in reduction of profits and reserves. In the circumstances, we do not wish to express any opinion on the constitutional validity of the said AS 22. Whether the said Standard constitutes a restriction on the rights of the appellants to cany on business under Article 19( l )(g) or whether the said H

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A Standard is violative of Article 14 are questions on which we express no opinion. We keep those questions open. Suffice it to state that, in the present case, we are of the view that the said AS 22 is neither ultra vires nor inconsistent with the provisions of the Companies Act, including Schedule VI. B

136. For the aforestated reasons, we find no infinnity in the impugned judgment of the High Court and, accordingly, the civil appeals filed by the various companies stand dismissed with no order as to costs. K.K.T. Appeals dismissed.