Analysis, Income Tax

Capital Expenditure vs Revenue Expenditure

The question about the nature of expenditure has always been a highly contested issue in tribunals and courts in India. Characterising an expenditure as revenue or capital has tax implications. Revenue expenditure is taken into account while computing taxable profits and would be eligible for a tax deduction whereas on capital expenditure only depreciation can be claimed. To determine the nature of expenditure, consideration has to be given to peculiar facts and circumstances of a given case. Here, we have discussed most important cases explaining the concept of expenditure.

Interpretation of “expenditure incurred”

Indian Molasses Co. Ltd. vs.Commissioner Of Income Tax

CIVIL APPEAL NO. 395 OF 1957, Supreme Court (cited +270)

In this case, the court considered the meaning of “expenditure” under s. 10(2)(xv) of IT, Act 1922. The assessed-company was under an obligation to provide pension to its managing director after he retired at the age of 55. In pursuance of this, the company executed a trust deed in favour of three trustees to whom it paid a lump sum of Rs 8,208 and further undertook to pay annually Rs. 4,364 for six years. The trustees were to spend this sum to take an annuity policy for the managing director. The dispute related to the sums transferred by the assesse-company to trustees to take an annuity policy for the managing director.

It was held that this payment by the company was contingent and therefore not deductible for income tax purposes. The director was alive then and it was not known whether any pension would be payable to him at all. Expenditure is a transaction, which is paid out and has gone irretrievably from the pockets of an assessee. Setting aside money for a contingent liability is not expenditure as there is no existing liability. There should be no possibility of funds forming a part of the funds of the assessee.

“In our opinion, the payment was not merely contingent but the liability itself was also contingent. Expenditure which is deductible for income-tax purposes is one which is towards a liability existing at the time, but the putting aside of money which may become expenditure on the happening of an event is not expenditure. In the present case, nothing more was done in the accounting years. The money was placed in the hands of trustees and/or the insurance company to purchase annuities of different kinds, if required, but to be returned if the annuities were not bought and the setting apart of the money was not a paying out or away of these sums irretrievably.”

The test of long and enduring benefit

Empire Jute Co. Ltd. vs.Commissioner Of Income Tax

Civil appeal no. 1191 OF 1974, Supreme Court (cited +230 time)

In the said case, assesse was a company carrying on the business of manufacture of jute and was a member of Indian Jute mills association. The members of association entered into an agreement restricting the number of working hours per week to run their looms. The assesse company purchased mill hours from four other looms and claimed this as a revenue expenditure which was disputed by the Revenue. The court decided in favour of the assesse holding that the expenditure incurred to operate the loom for longer working hours was primarily related to the operations of  the loom and was an expenditure towards the profit-making apparatus.

The court held that the test of long and enduring benefit cannot be applied in the current case, for classifying the transaction as a capital expenditure. The test of long and enduring benefit cannot be applied where the advantage consists of facilitating the assesse’s trading operations, leaving the fixed capital untouched. The purchase of loom hours did not create any new assets nor was there any expansion of the factory.

“There may be cases where expenditure, even if incurred for obtaining an advantage of enduring benefit, may, nonetheless, be on revenue account and the test of enduring benefit may break down.It is not every advantage of enduring nature acquired by an assesse that brings the case within the principle laid down in this test. What is material to consider is the nature of the advantage in a commercial sense and it is only where the advantage is in the capital field that the expenditure would be disallowable on an application of its test.If the advantage consists merely in facilitating the assessee’s trading operations or enabling the management and conduct of the assessee’s business to be carried on more efficiently or more profitably while leaving the fixed capital untouched, the expenditure would be on revenue account, even though the advantage may endure for an indefinite future. The test of enduring benefit is, therefore, not acertain or conclusive test and it cannot be applied blindly and mechanically without regard to the particular facts and circumstances of a given case.”

Expenditure incurred to raise money for business

India Cements Ltd. vs.Commissioner Of Income Tax

CIVIL APPEAL NO. 1106 OF 1964, Supreme Court (cited +411 times)

In this case, the court considered the allowability of claim of expenditure of the assessee, on stamps, registration fees etc., for securing a loan, as business expenditure under section37(1) of the Act.

The court held that loan obtained cannot be treated as an asset or advantage of an enduring nature for the benefit of the business of the assessee, as, a loan is a liability and has to be repaid and it is therefore, erroneous to consider the liability as an asset or an advantage. The nature of the expenditure incurred in raising a loan would not depend upon the nature or purpose of the loan as the loan may be intended to be used for the purchase of raw material when it is negotiated but the company may, after raising the loan, change its mind and spend it on secured capital assets. The expenditure incurred for availing loan was held to be allowable u/s 37(1)of the Act.

“But we are unable to agree that a loan obtained can be treated as an asset or advantage for the enduring benefit to the business of the assessee. A loan is a liability and has to be repaid and, in our opinion, it is erroneous to consider a liability as an asset or an advantage within the test laid down by Viscount Cave and approved and applied by this Court in many cases.”

Lump sum payment to obtain technical know-how in medical industry

Alembic Chemical Works Co. Ltd. vs CIT,

CIVIL APPEAL NO. 43 OF 1975, Supreme Court (cited +410 times)

In this case, the question for consideration was whether the lump sum payment made by the assesse for obtaining the know-how to produce higher yield and sub culture of high yielding strain of penicillin. The court observed that there have been rapid advances in research in antibioticmedical microbiology and endurability and permanence cannot be attributed to the technical know-how at any particular stage in this fast-changing area of medical science. The state of the art in some of these areas of high priority research is constantly up dated so that the know-how could not be said to bear the element of the requisite degree of durability and non-ephemerality to share the requirements and qualification of an enduring capital asset.

“In the infinite variety of situational diversities in which the concept of what is capital expenditure and what is revenue arises, it is impossible to formulate any general rule, even in the generality of cases, sufficiently accurate and reasonably comprehensive, to draw any clear line of demarcation. However, some broad and general tests have been suggested from time to time to ascertain on which side of the line the outlay in any particular case might reasonably be held to fall. These tests are generally efficacious and serve as useful servants; but as masters they tend to be over-exacting.”

Nature of expenses incurred on upgrading, improving or removing problems in an existing old product

CIT vs ACL Wireless Ltd

ITA 254 of 2013, Delhi HC (cited +720 cases)

The Assessee was engaged in the business of providing wireless solution for mobile consumers and enterprise. To keep pace with the requirements and ensure product saleability, software development companies have to constantly incur expenditure to upgrade, improve and remove problem areas of the software. The nature of such expenditure was called in question.

The court held that the assessee has to employ professionals whose job is to continuously upgrade the software and provide newer features and updates on are gular basis. In case the expenditure is not incurred on the said capital asset the same would become unsalable and obsolete. Therefore, to ensure marketability of the existing repeated and constant cost had to be incurred to upgrade and remove glitches etc. Accordingly, the expenditure was held to be revenue expenditure.

(Written by Anuj Sharma, Product Counsel @ Riverus)

Also Read: Can deduction u/s 80-IA be claimed if the contract is awarded to Joint Venture formed by the assessee?

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