1.33     Query

Treatment of “Royalty”, “Development Rebate”and “General

Provident Fund in Accounts.

1 A company was having a lease of mines and every year rent of Rs. 2 lacs was paid by the company. Subsequent as a result of negotiations between the State Government and the company it was agreed that only royalty may be commuted and in pursuance of agreement a sum of Rs. 40 lacs was paid by the company to the State Government. It may kindly be advised whether it should be shown under the head “Fixed Assets” or under the head “Miscellaneous Expenditure” to be written off in the Balance Sheet. The Company is writing off Rs. 2 lacs per year out of the computed value of royalty rights.

2.         Whether development rebate reserve should be shown as appropriation of profit or should be shown in Profit and Loss Account.

3.         A company has purchased a car for Rs. 30,000 and after a year when its written down value was Rs. 22,500 sold it for Rs.35,000. Whether the capital gain of Rs. 5,000 made by the company on the sale of this car should be shown separately in the Profit & Loss Account as capital gain or whether the same should be transferred to the Capital Gain Reserve Account in the Balance Sheet.

4.         General Provident Fund is neither a current liability nor a provision, and therefore, kindly let us know whether the same could be shown in the Balance Sheet.

Opinion                                                                                                                   April 5, 1976

The sum of Rs. 40 lakhs paid to the State Government from the facts disclosed could be regarded as the capitalised value of leasehold rights. As such it can be shown as fixed assets itself, under the heading “Leasehold Rights into mines”. As regards writing off this sum, two methods may be open to the company: (a) based upon the expected annual exploitation, the life of the lease can be ascertained and accordingly 1/n of the leasehold rights could be written off every year – ‘n’ representing the useful life of the leasehold,  (b) the annual write off could be done as a proportion of the actual exploitation in a year compared to the total reserves estimated.

 2In view of the Board’s Circular dated 21^st July, 1966 the assessee company would be entitled to create the development rebate reserve by debiting either the Profit and Loss Account  or the Profit and Loss Appropriation Account of the relevant accounting year.  However, in cases where the debit is to the Profit and Loss Appropriation Account, the assessee must take care to see that the profits of the current year are sufficient to permit the creation of the reserve.  In other words, the reserve created by debiting the Profit and Loss Appropriation Account should not exceed the profits of the current year.

  While some companies have been creating the development rebate reserve by debiting the amount thereof in the ‘above-the-line’ section of the Profit and Loss Account in which the profits of the relevant year are arrived at, others have been making the debit in the ‘below-the-line’ section of the Profit and Loss Account, often referred to as the Profit and Loss Appropriation Account, which inter alia, contains credits for the profit, if any, brought forward from the earlier years or amounts transferred from various reserve accounts of the company.  The provisions in Part II of Schedule VI to the Companies Act, 1956, in regard to the requirement as to the Profit and Loss Account do not make a distinction between the ‘above-the-line’ and ‘below-the-line’ sections of the Profit and Loss Account.  The debit for development rebate reserve in the ‘below-the-line’ section of Profit and Loss Account is, therefore, to be regarded as adequate compliance with the condition in Section 34(3)(a) of the Income-tax Act that the debit should be made to the Profit and Loss Account of the relevant previous year.

 3The question has been raised presumably keeping in mind the two famous case laws on the subject of distribution of capital profits namely—“Lubbock Vs. the British Bank of South America” and “Foster Vs.  The New Trinidad Lake Asphalt Co. Ltd.”  The result of the judgement in these two cases is that capital profits are available profits only if all the three conditions are fulfilled.

             (i)         the Articles of Association permit such distribution.

            (ii)        the surplus is realised and

(iii)       such surplus remains after a proper valuation of the whole of the assets has been fairly taken.

The spirit behind the judgement is that the capital profit must have arisen out of the sale of a major part or substantially the whole of the undertaking of a company and does not refer to sale of petty assets like a car or some other small part of the assets of the company, even though such a sale might yield technically a capital profit.  Usually in such small sales the resultant profits are not likely to have a materiality in the available surplus for distribution.  Hence it is permissible to credit such small capital gains to the Profit and Loss Account itself instead of being transferred to a Capital Gain Reserve Account appearing in the Balance Sheet.  Even where the capital gains are large and the three conditions stated above are satisfied the capital gains can still be credited to Profit and Loss Account without being transferred to Capital Gain Reserve Account.

Schedule VI mentions about a capital reserve and not a capital gains reserve.  Whereas a capital gain may also be regarded as a capital reserve, a capital reserve need not necessarily arise out of a capital gain.

Even from the Income tax point of view it would be advisable to show it clearly in the Profit and Loss Account under the head “Profit” or “Loss on sale of capital asset”. 

4.If the employee’s contribution towards the General Provident fund has already been recovered by the company, then it owes a liability to remit it to the authority administering the Provident Fund.  Hence this unremitted balance should be shown under the head “Current Liabilities

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