1.15 - Query

Entries in the Account Books under Section 34(3)
of the Indian Income Tax Act, 1961.

Specific problem arises from the operation of Section 34(3) of the Indian Income-Tax Act. The specific details are given under: -

1. That the Assessee purchased machinery worth about Rs. 60,000/- only during the accounting year 1962-63. He created a reserve equivalent to Rs. 12,000/- only by debiting Profit & Loss Account. This was done under Section 34(3) of the Act and the assessment was accordingly completed.

2. In the year 1964-65, the Assessee concerned purchased machinery worth Rs. 5,000/- only. He passed the following entries in his books of accounts: -

(a) At the time of purchase of machinery :
Development Rebate Reserve A/c. Dr. Rs. 5000/-
To Supplierís A/c. Rs. 5000/-

Narration (Being the amount of machinery purchased out of the reserves created under Section 34(3) of the Indian Income Tax Act.)

The above entry was passed in the first week of August, 1964. The concerned client passed the following two entries on the next day: -

(i) Machinery A/c. Dr. Rs. 5000/-
To Development Rebate Reserve A/c. Rs. 5000/-

Narration (Being the amount of machinery purchased out of the utilization of the
Development Rebate Reserve.)
(ii) Development Rebate Reserve A/c Dr. Rs. 5000/-
To Partnerís Capital A/c Rs. 5000/-

Narration (Being the amount of Development Rebate Reserve released and transferred to

Partnerís Capital Account under Section 34(3) of the Indian Income Tax Act.)

3. During the course of assessment for the assessment year 1965-66, the I.T.O. objected to the entries made by the Assessee in his account books and proceeded to re-open the case for the assessment year 1963-64 under Section 155(5) of the Act on grounds that the reserve has fallen short of the minimum requirement of 75%. The case has been referred to by the counsel of the Assessee who has already preferred an appeal with A.A.C.

4. According to the requirements of the law, the Development Rebate is admissible provided: -

(a) An amount equal to 75% of the Development Rebate to be actually allowed is debited to the Profit & Loss Account of the relevant previous year and credited to Reserve Account to be utilized by him during a period of 8 years next following for the purpose of the business of the undertaking except Ė
(i) for distribution by way of dividends or profits.
(ii) --
(iii) --

In the above provisions of the law, a specific procedure has been provided in the Act itself for the purpose of creating the Development Rebate Reserve.

5. I am unable to find any provision in the Act whereby there is any provision made for the purpose of the utilization of the Reserve. You will agree with me that there should be some entry which should be passed by the commercial organizations claiming Development Rebate which should not only fulfill the requirements of the law but should also be correct in accordance with the agreed principles and practice of the accounting system. In case the necessary entry is not passed in the books of accounts within a period of 8 years next following the previous year in which the Reserve was so created, I am afraid the creating of Reserve may not fall within the purview of Section 155(5) of the Indian Income Tax Act because failure to utilize the Reserve for the purpose for which it was created shall invoke the provisions of Section 41 of the Indian Income Tax Act and consequently may result in invoking the provisions of Section 155(5) of the Act. You will further agree with me than as soon as the requirements of the law are fulfilled by utilization of the said amount for the purpose of the business of the undertaking the reserves shall be released and the partners shall be free to utilize the same even for the purposes of distributing it by way of dividends or profits or alternatively for transferring it to a general reserve or even the partnerís Capital Account.

6. Under the circumstances, advice is sought for necessary entries which shall be passed in the books of accounts at the time when the reserves created under Section 33 of the Indian Income Tax Act are desired to be utilized and the way to deal with such reserves, since they will be deemed to be discharged.



Opinion

August 26, 1967

The provisions of the Income-tax Act relating to the creation of a Development Rebate Reserve are based upon a common mis-conception about the nature of a reserve which occurs in the minds of non-accountants. To an accountant it would be clear that machinery can be purchased only out of funds lying with the company or out of monies borrowed for that purpose. The existence or absence of a Development Rebate Reserve account would make no difference. The idea of purchasing machinery out of Development Rebate Reserve is from the accounting point of view not absolutely correct. It can be inferred from relevant facts of the case. Under the circumstances, two kinds of practices are being followed by companies in the treatment of Development Rebate Reserve.

The first practice and the safer one is to let the Development Rebate Reserve account remain untouched over the statutory period of eight years and thereafter transfer it to a General Reserve account. In the opinion of the Committee such a procedure fully meets the requirements of Section 34 of the Income-tax Act.

The alternative procedure which has been followed by a minority of companies is, that if in the year succeeding the year in which the Development Rebate Reserve is created an amount equal to or in excess of the amount so set aside is expanded for the purposes of the business e.g., for purchase of machinery, the balance to the credit of the Development Rebate Reserve accounts is transferred in that year to a General Reserve account. This practice appears to have been accepted by the Income-Tax Department in some cases.