PRECOMMENCEMENT INCOME / EXPENSE |
Business income ID – 61 (JBC-006) |
Set up of business
A business is nothing more than a continuous course of activities and for commencement of business all the activities which go to make up the business need not be started simultaneously. As soon as an activity which is the essential activity in the course of carrying on the business is started, the business must be said to have commenced. A finding regarding the date when a business was set up is a finding of fact. Under section 3 of the Income-tax Act, 1961, it is the “setting up” of the business and not the “commencement” of the business that is to be considered. A business is commenced as soon as an essential activity of that business is started. Thus, a business commences with the first purchase of stock-in-trade, and the date when the first sale is made is immaterial. Similarly, a manufacturer has to undertake several activities in order to bring to produce finished goods and he commences his business as soon as he undertakes the first of such activities. CIT v. Saurashtra Cement and Chemical Industries Ltd. [1973] 91 ITR 170 (Guj) followed.
In CIT v. ESPN Software India (P.) Ltd. [2009] 184 Taxman 452 (Delhi), the assessee-company was incorporated on 1-8-1995. On 15-8-1995, it had acquired a licence from its parent company to sub-licence ‘ESPN’ services for distribution of programmes in India via cable television system. By virtue of licence, the assessee entered into an agreement on 1-10-1995 with a company and appointed it as its sole distributor for distribution of ESPN programmes in India.
The Delhi High Court read that it is well-settled that business is nothing more than a continuous course of activities, and for commencement of business all the activities, which go to make up the business, need not be started simultaneously and as soon as an activity, which is the essential activity in the course of carrying on the business, is started, the business must be said to have commenced. The Court then held that in this case the assessee was ready to commence its business on 15-8-1995, when it acquired license to distribute in India through cable television systems, Satellite Master Antenna Systems and DTH, etc. By virtue of the license, it could discharge one of its objects as set out in the Memorandum of Association of the company. That was the activity, which was first in point of time and which must necessarily precede all other activities and on that activity being done, the business of the assessee would be deemed to have been set up.
Section 284(75) of the Direct Taxes Code also so defines ‘date of setting up of business’ as the date on which it is ready to commence its commercial operations.
Following the Supreme Court decision in Sarabhai Management Corpn. Ltd. v. CIT [1976] 102 ITR 25, the Calcutta High Court in Tetron Commercial Ltd. v. CIT [2003] 261 ITR 422 / 133 Taxman 781 held that the business commences on the first step for commencement of the business if undertaken. The Delhi High Court in CIT v. Hughes Escorts Communications [2007] 165 Taxman 318 held that in the case of a company incorporated for carrying on the business of setting up satellite business communication systems its business would be set up on the date on which it placed the order for purchase of VSAT equipment and, thus, any expenditure incurred thereafter be considered as revenue expenditure.
Pre-operative interest incomes
In Indian Oil Panipat Power Consortium Ltd. v. ITO [2009] 181 Taxman 249 (Delhi), the assessee joint venture company was to put up a power project. Funds such as share capital and additional share capital were raised for purchase of land and development of infrastructure, but due to legal entanglements with respect to title of land, they were temporarily put in fixed deposit with bank and interest was earned thereon. Whereas it claimed that said interest was capital receipt and, therefore, should be set off against pre-operative expenses, the Assessing Officer treated the interest as ‘income from other sources’.
Between the two decisions of the Apex Court in CIT v. Bokaro Steel Ltd. [1999] 236 ITR 315/102 Taxman 94 and Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT [1997] 227 ITR 172/93 Taxman 502 relied upon by either side, the Delhi High Court found Bokaro Steel Ltd.’s case (supra) most appropriate to the situation as it found that the funds held with the assessee were not surplus funds but funds which were inducted into the joint venture company by the joint venture partners, primarily to purchase land and to develop infrastructure. Further, taking a clue from section 3 of the Act, the Court held that the previous year shall be the period beginning with the date of setting up of the business so that any income earned during setting up stage must be offset against pre-operative costs.
Interest Income | Treatment |
Share capital kept in Bank for asset acquire (Indian oil panipat power (Del)) | Reduce cost |
Interest income on surplus funds (Bokaro steel (SC)) | IFOS |
Interest paid (Challapali Sugar (SC)) | Add to cost |
Interest paid during the pre-commencement period would be required to be capitalised as decided in Challapalli Sugars Ltd. v. CIT [1975] 98 ITR 167 (SC). The rationale of this decision in converse facts would require that interest receipt should be an abatement of capital cost, a view not followed in Tuticorin Alkali Chemicals and Fertilizers Ltd. v. CIT [1997] 227 ITR 172 (SC). But all the same, a series of decisions thereafter would favour a different view as in CIT v. Bokaro Steel Ltd. [1999] 236 ITR 315 (SC) ; CIT v. Karnataka Power Corporation [2001] 247 ITR 268 (SC) and Bongaigaon Refinary and Petrochemicals Ltd. v. CIT [2001] 251 ITR 329 (SC). A limited claim for adjustment of interest paid against the interest received was recognised in CIT v. VGR Foundations [2008] 298 ITR 132 (Mad), wherein the later decisions of the Supreme Court have been preferred to the decision in Tuticorin Alkali Chemicals and Fertilizers Ltd.’s case (supra). The further claim that the surplus, if any, of interest receipts over interest payment should be treated as abatement of capital cost did not arise in this case.
Interest income earned before the commencement of business should ordinarily be assessable under the head “Other sources”. It may be capitalised, if such interest has nexus with the setting up of a plant. If it does not have such nexus, it may well be assessable as income taxable during the year. In Central Travancore Specialists Hospital Ltd. v. Asst. CIT [2008] 302 ITR (AT) 131 (Cochin), it was found that in the facts of the assessee’s case, there was no nexus for such interest with the setting up of the plant and that the interest was from surplus funds which were kept with the bank to earn interest. Notwithstanding the possible difference between the decision in CIT v. Bokaro Steel Ltd. [1999] 236 ITR 315 (SC) and in some other cases, it was felt that the facts of the case warranted the application of the principle in Tuticorin Alkali Chemicals and Fertilizers Ltd. v. CIT [1997] 227 ITR 172 (SC), so that the Tribunal upheld the order of the authorities that such interest income was taxable.
Interest earned / paid in pre-commencement period
One of the controversies on which courts have taken contrary views is the treatment to be accorded to interest earned on deposits, whether it is abatement of capital cost or chargeable income. Interest has always been considered as a flow and, therefore, income as distinguished from a fund with the character of capital. Yet, the Supreme Court in Challapalli Sugars Ltd. v. CIT [1975] 98 ITR 167 had taken the view that for purposes of determining the actual cost for allowance of depreciation and development rebate, interest paid on amounts borrowed for the purpose of such depreciable assets could be treated as part of the cost. For coming to this conclusion, the Supreme Court relied upon the concept of capitalisation of interest as understood in textbooks in Accountancy as by Pickles, Spicer and Pegler and Cropper, Morris and Fison. Statement of Auditing Practice issued by the Institute of Chartered Accountants of India and certain English precedents relating to company law practice were also cited for this conclusion.
But what applied to interest payments in Challapalli Sugars' case, [1975] 98 ITR 167 (SC), was found inapplicable to interest receipts in Tuticorin Alkali Chemicals and Fertilisers Ltd. v. CIT [1997] 227 ITR 172, a judgment rendered by three judges. It found that even though the practice of capitalising receipt was recognised by the Institute of Chartered Accountants of India, it came to the conclusion that whether a particular receipt constitutes taxable income has to be decided according to the principles of law and not in accordance with accountancy practice. The Supreme Court observed: "Accounting practice cannot overrule section 56 or any other provisions of the Act". As was pointed out by Lord Russel in the case of BSC Foot Wear Ltd. [1970] 77 ITR 857 (CA), income-tax law does not march step by step in the foot-prints of the accountancy profession. In Challapalli Sugars' case [1975] 98 ITR 167 (SC), though accountancy principles were referred to and commercial practice was recognised, the interpretation of the expression "actual cost" was one of the factors which had prompted the conclusion apart from accounting practice. This decision was rendered on a direct reference by the Tribunal to the Supreme Court in view of the conflicting views of the High Courts.
Receipts prior to Setting up Business.
A business must be carried on before there can be any profits and gains. Any receipt, received before the business is carried on, is not a business receipt and if any expenditure is incurred before the business has started, it is also not a business expense. Where the assessee received grants-in-aid before it started business, it could not be treated a business receipt [CIT v. State Trading Corporation of India Ltd. (1973) 92 ITR 294 (Del.)].
Similarly, where an assessee is awarded the work of erecting and commissioning plant and machinery to a contractor before the commencement of the business and for speedy execution of the work and he is allowed accommodation for his workers on the site, also allowed to use certain plant and machinery of the assessee and is also given advances for this purpose, the receipts from the contractor on account of rent and royalty are not assessable as business income but should be reduced from the capital cost of the machinery to be erected [CIT v. Bokaro 236 ITR 315 (SC)].
Whether income-Pre-operative receipts are on capital account
An important decision has been rendered by the Supreme Court in CIT v. Bokaro Steel Ltd. [1999] 236 ITR 315 dealing with an issue of receipt in a business which is yet to be set up. In the matter of interest received on short-term deposits, the Supreme Court had earlier decided in Tuticorin Alkali Chemicals and Fertilizers Ltd. v. CIT [1997] 227 ITR 172 that it had to be assessed as income and could not be treated as an abatement of capital cost as claimed on the basis of converse inference from a decision of the Supreme Court in Challapalli Sugars Ltd. v. CIT [1975] 98 ITR 167. This decision had given rise to a sense of regret as it made a departure from accounting principles and had also imposed a burden on a business in the making by taxing what is purely incidental to the act of setting up such business. It was apprehended that though the decision related to interest, it would have application even for other miscellaneous receipts, but there is a silver lining in the decision of the Supreme Court in CIT v. Bokaro Steel Ltd. [1999] 236 ITR 315 in that the Supreme Court has found a different solution in respect of miscellaneous receipts like income received from contractors by way of rent, interest on advance payments to them, machinery hire and royalty for excavation of stones used for construction work. There was also interest receipt which, however, did not come up before the Supreme Court so that the Supreme Court observed that this issue relating to interest was not before it and that, at any rate, it is already covered by Tuticorin Alkali Chemicals' case. However, in respect of other miscellaneous receipts it found that the reliance placed in Tuticorin Alkali Chemical's case was misconceived. The observation in that case that the rental income of a company received by it even before commencement of business may be taxable, it was explained, was not applicable to receipts which are inextricably linked with the setting up of the capital structure of the assessee. The Supreme Court in Bokaro Steel Ltd.'s case points out to the parallel in Challapalli Sugars' case, an argument which failed in Tuticorin Alkali's case. It was felt that accountancy rule which would treat such payments and receipts during construction period as on capital account should prevail.
The judgment also makes a reference to the concept of real income though it was not a basis for its conclusion. This unexceptionable decision in Bokaro Steel's case, with respect, would mean that the decision in Tuticorin Alkali's case would require reconsideration at a future date so as to harmonise the inference in contingencies similar to the one arising in Tuticorin Alkali Chemical's case with the conclusion arrived in Challapalli Sugars' case and now Bokaro Steel's case.
Pre-commencement expenditure
Expenditure incurred in respect of any business is deductible from the date of commencement of business but only where it has been set up. Expenditure incurred prior to the setting up of a business is not allowed as a deduction. Pre-commencement expenditure may well be a dead loss unless it could be treated as cost of the capital asset so as to be entitled for depreciation.
The distinction between setting up and commencement of business is one which will cause tax problems for the first year of ones business especially in manufacturing line and such problem may sometimes extend to more than a year, where there is a long gestation period for a particular line of business. It was pointed out in the case of CIT v. Bihar Spinning & Weaving Mills Ltd. That the fact that the business was in the second year of its commencement does not mean that the expenses are deductible unless it is shown to have been set up. The result is that the income earned during this period may well be taxable as income from other sources, while the expenditure would be treated as one not admissible, the assessee suffering both ways.
The view that the income earned is incidental to the activity for setting up the business as in the case of sale of scrap or gunny bags or interest income from deposits of moneys pending use, the share contributions or borrowings could be treated as abatement of capital cost has not found favour with many courts. In Tuticorin Alkali Chemicals & Fertilisers Ltd. v. CIT the Supreme Court held that moneys earned prior to commencement of business, viz., interest earned on deposits made out of borrowed funds was taxable and could not be set off against interest payable on borrowed funds.
Tax planning is sometimes thought of by having a trial run for a new industrial undertaking, which would mean that the asset is brought to use, in an existing business so that depreciation can be claimed, but a successful trial is claimed only early next year so that depreciation for the assets can be got in an earlier year, while the period for relief would be reckoned only from the next succeeding year. This happens because the income of a new industrial undertaking would be reckoned after it starts manufacturing goods, while depreciation is available once the machinery is brought to use, another refinement in law giving ample scope for tax planning in one sense and controversy in the other.
Expenditure after ‘setting up’ but before ‘commencement’
Expenses incurred in the interregnum between the ‘setting up’ of a business and the ‘commencement of business are deductible. Any expenses incurred prior to the setting up of a business would obviously not be permissible deductions because those expenses would be incurred at a point of time when the previous year of the business would not have commenced - Western India Vegetable Products Ltd. V/s. CIT [1954] 26 ITR 151 (Bom.).
Inauguration expenses
Merely because the expenditure was incurred before the commissioning of a new unit would not make it any the less an expenditure coming under section 37(1) if it satisfies all the other conditions. Where the assessee was already having manufacturing units and had only expanded its existing business and inaugurated another new project, expenditure incurred by it in connection with the inaugural function of that unit was allowable as revenue expenditure - CIT V/s. Aluminium Industries Ltd. [1995]214 ITR 541 (Ker.). See also CIT V/s. Hindustan Aluminium Corporation Ltd. [1989] 176 ITR 206 (Cal.)
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