No disallowance of cash payment under section 40A(3) of the Act if transaction is genuine and meets business expediency test
The genuineness of the transactions and it being free from vice of any device of evasion of tax is relevant consideration. The intent and the purpose for which section 40A(3) of the Act has been brought on the
An incorporated public company or private company having share capital commences business after obtaining certificate for commencement under the Companies Act, 2013. But after obtaining the certificate of incorporation, generally a company takes several years to commence its business operations specifically in industries such as power-generation, production of petroleum and natural gas, telecommunication services etc. It is evident from the nature of business that the companies functioning in such industries shall have long gestation period till the time it could be brought to a stage of performance. Until than the company expends towards initial set-up cost on factories, plants, advanced machineries developing the capital structure of the company. These expenses are referred as pre-operative expenses. Therefore, the expenses incurred after obtaining the legal existence of the company till the time company commences its actual production, including the normal expenses such as salary and rent incurred are known as pre-operative expenses. This article discusses one of the prominent issues related to taxability of income during the gestation period.
Generally to set-up a business, company requires lot of funds. In order to meet the funds requirement at large scale, the company takes loans from banks and other financial institutions. At times, a company may not utilize a substantial part of loan due to some obligations prevalent in its internal environment. In such scenario, company utilizes only part of loan and rest of the funds may be temporarily parked in some potential investment with a view to earn interest. This very action of companies is justifiable too on ground that instead of keeping funds idle, it was invested and later on, it could be redeemed as and when there will be requirement of funds. So, when unutilized loan is invested somewhere else it may earn some interest income also. This means that even if company is not earning any income from its operations and it is yet to start its commercial production, it may still earn income by investing idle funds.
Now the question arises whether a company can set-off (adjust/reduce) its pre-operative expenses from income from other sources during a financial year?
It is generally accepted principle that the pre-operative expenses incurred during the construction phase or cost expended on setting-up of plant can be reduced from the income earned during the year and thereafter profit or loss as the case may be, can be calculated. But such is not the case with Income-tax Act, 1961 (the Act). As per the provisions of the Act, the company cannot set-off pre-operative expenses with the income which are not inextricably linked with the business activities. However, pre-operative expenses may be capitalized towards the cost of assets. Now it may be noted that a company may not have business income till initiation of its commercial production but it doesnt mean that it will not have income from any other source as well. Hence the assessment of income from other sources can be done even if the company has not started its commercial production.
The issues which generally arise, when company is yet to start its commercial production are enumerated below:
Can a company can reduce its income from other sources by pre-operative expenses in setting-up phase?
Companies often make borrowings from banks and other financial institutions for the purpose of setting up of factories, installation of plant and machineries etc. But in due course, it is possible that a company might not be able to utilize its whole amount of loan. Subsequently, the company may invest the unutilized amount of loan in fixed deposits and earn interest on the same. Here, in this scenario, pre-production expenses are considered as capital in nature; on the contrary, interest earned on fixed deposits earned from independent source and not from business operations is revenue in nature. So two items of different nature cannot be clubbed together or reduced from each other. Accordingly, income from independent source is always taxable unless specifically exempted by Act.
Whether interest received on borrowings can be treated as capital receipts only because company has not commenced its business?
If the company, even before its commencement of business, invest the surplus funds which is lying idle in its hands for purchase of land or house property and later sells it at profit, than the gain made by the company will be assessable under the head Capital gains. Similarly, mere on this ground (non-commencement of business), interest received on short-term fixed-deposits or other investment avenues could not be treated as capital receipts nor can be subsequently capitalized in the books of accounts. Hence such receipts ought to be treated as revenue receipts and accordingly must be taxed.
Such a view was taken by Supreme Court in Tuticorin Alkali Chemicals and Fertilizers Ltd. v CIT.
On the contrary, if the money placed in the fixed deposit inextricably linked with the setting up of the power plant, then the revenue generated on account of interest on the said fixed deposits would be in the nature of a capital receipt and not a revenue receipt. This view was taken by High Court in Pr. Commissioner of Income-tax v Facor Power Ltd.
Whether setting-off interest income received on fixed deposit (which is a part of unutilized amount of borrowed fund) with interest payable on such borrowed fund is prudent as per the Act, 1961?
From the above points, there is a clear understanding that the expenditure incurred by the assessee for the purpose of setting up of its business cannot be allowed as deduction nor can be adjusted against income under any other head but it can be capitalized if nature of the expenditure is capital. But the obvious question which arises at this juncture is that Whether such kind of adjustment cannot be entertained in any situation whatsoever?
The interest earned on funds primarily brought for infusion in the business could not have been classified as income from other sources. Since the income was earned in a period prior to commencement of business, it was in the nature of capital receipt and hence was required to be set off against the pre-operative expenses. This view was taken by Ahmedabad tribunal in Adani Power Ltd. v ACIT. The same view was taken in Indian Oil Panipat Power Consortium Ltd. v Income-tax Officer.
Whether source of income can detract the revenue character of the receipts?
Source of income can detract the revenue character of the receipts of short-term fixed deposits if such receipts have accrued out of that fund which was originally a loan and later the unutilized loan was converted into fixed deposits and the deposits were inextricably linked with the setting up of the capital structure of the company.
However, the company cannot claim the adjustment of this expenditure against interest assessable u/s 56 of the Act. In such cases, the source of income cannot detract the revenue character of the receipt. This view was taken in Kedar Narain Singh v. CIT.
Whether interest received from the contractor is also in line with the interest on short-term deposits?
The advances made to contractors to facilitate the construction activity (say installation of plant) of putting together a very large project cannot be considered in line with interest on short-term deposits. In normal course of business, it is often provide to ensure that the work of the contractors should proceed without any financial hitch. The arrangements which are agreed upon by the company and the contractors pertaining to receipts of advanced are actually arrangements which are connected with the construction of plant intrinsically.
On the contrary, had this facility not been provided by the company, the contractors would have had to make their own arrangements and this would have been reflected in the charges of the contractors for the construction work. Instead, the company had provided these facilities. The same was true of the hire charges for plant and machinery which was given by the assessee to the contractor for the assessee's construction work. The advances which the assessee made to the contractor to facilitate the construction activity of putting together a very large project was as much to ensure that the work of the contractors proceeded without any financial hitches as to help the contractors. The receipts had been adjusted against the charges payable to the contractors and had gone to reduce the cost of construction. They had, therefore, been rightly held as capital receipts and not income of the assessee from any independent source. Such a view was taken by Supreme Court in CIT vs. Bokaro Steel Ltd.
Ø No surplus funds, since liability towards creditors exist towards project development;
Ø Surplus funds, since liabilities are paid-off;
Ø Interest is earned on funds primarily meant for acquiring land for development of infrastructure;
Ø Interest is earned on funds in a period prior to commence of operations and where development of infrastructure is complete and creditors are paid in full;
Ø Capital Receipt, hence, non-taxable
Ø Revenue Receipt, hence, taxable
Ø Relevant case law: Commissioner of Income-tax v. Bokaro Steel Ltd.
Ø Relevant case law: Tutikorin Alkali Chemicals & Fertilizers Ltd.
Whether well-established accounting practice can override the provisions of Income-tax Act?
From a prudent accounting prospective, there is no harm in setting off interest earned on unutilized borrowed capital against interest payable by the company on that borrowed capital. But the well-established accountancy practice cannot override the provisions of Income-tax Act, 1961. This view was taken by Apex Court relying on case of B.S.C. Footwear Ltd. v. Ridgway (Inspector of Taxes). We are concerned with the taxability of an income and not its accounting in books. When the question arises whether a receipt of money is taxable or not or whether certain deductions from that receipt are permissible in law or not, the question has to be decided according to the principles of law and not in accordance with accountancy practice.
It is well established fact that tax is attracted at the point when the income is earned. Taxability of income is not dependent upon its destination or the manner of its utilization. It has to be seen whether at the point of accrual, the amount is of revenue nature or not. If the amount is of revenue nature, the amount will have to be taxed. This view was also taken in Pondicherry Railway Co. Ltd v. CIT (1931) 1 Comp. Cas. 314; AIR 1931 PC 165."
Further, Central Government has notified 10 Income Computation and Disclosure Standards (ICDS) applicable w.e.f. A.Y. 2017-18 for the purpose of computation of income under the head PGBP and other sources. ICDS-IX deals with the treatment of interest paid for borrowings and whether such interest is revenue expenditure or capital expenditure and how it must be treated by the assessee.
It states that the borrowing cost in respect of specific borrowings undertaken for acquisition of tangible or intangible assets or inventory which requires a period of 12 months or more to bring them to a saleable condition is liable for capitalization. However, in case of borrowings not undertaken for qualifying assets i.e. a general borrowing with interest payable thereon, the proportionate amount of borrowing cost attributable to the qualifying asset for the period before the asset is put to use shall be capitalized and the interest for the period after first use will be treated as revenue expenditure.
From the above discussion it becomes very clear that non-inception of business cannot be used as weapon to evade tax on that income which is not the business income and is derived from other sources. The above discussion can be summarized as follows in relation to newly set-up business:
If expenses are in nature of preliminary expenses, then such expenses are allowable u/s 35D of the Act.
If expenses are in nature of pre-operative expenses, then they can be capitalized with the cost of assets but deduction of same cannot be taken.
If company is receiving any income from independent source, then same cannot be set-off against any of the pre-operative expenses or interest payable on loan earlier procured.
If company is receiving any interest income whose source is inextricably linked with the setting-up of capital structure of company, then income earned may be set-off against the interest payable on such loan.
If the company has undertaken borrowings in respect of qualifying assets, the expenditure incurred towards borrowing costs from the date of borrowing till the asset is acquired/constructed or put to use shall be capitalized to the cost of the asset whereas borrowing cost not meant for qualifying assets is eligible for deduction as revenue expenditure.
Following case-laws can give more insights on the above discussed issue.
Tuticorin Alkali Chemicals and Fertilizers Ltd. v Commissioner of Income-tax (1997) 65 CCH 0523 ISCC :  227 ITR 172 (SC)
Pr. Commissioner of Income-tax v Facor Power Ltd. (2016) 95 CCH 0004 DelHC :  66 taxmann.com 178 (Delhi).
CIT vs. Bokaro Steel Ltd. (1998) 66 CCH 1294 ISCC : 236  ITR 315 (SC)
Adani Power Ltd. v ACIT (2015) 44 CCH 0427 AhdTrib :  61 taxmann.com 355(Ahemdabad-Trib)
Indian Oil Panipat Power Consortium Ltd. v Income-tax Officer (2009) 77 CCH 0218 DelHC :  181 Taxman 249 (Delhi).
Kedar Narain Singh v. CIT (1938) 6 CCH 0001 AllHC :  6 ITR 157
Pondicherry Railway Co. Ltd v. CIT (1931) 1 Comp. Cas. 314; AIR 1931 PC 165. (p. 182)
B.S.C. Footwear Ltd. v. Ridgway (Inspector of Taxes) (1970) 38 CCH 0026 CA :  77 ITR 857, 860
About the Authors
Maneet Pal Singh Pasricha, Partner, I. P. Pasricha & Co., New Delhi
Maneet Pal Singh is a member of the Institute of Chartered Accountants of India. He is a partner in I. P. Pasricha & Co., New Delhi. He has experience in the field of Direct Taxation. He has extensive experience in advising clients across a range of industries in assessments/ transfer pricing assessments, returns filings, drafting opinions, preparation of Transfer Pricing Study reports.
Deepak Suneja: Senior Manager, I. P. Pasricha & Co., New Delhi
Deepak Suneja is a member of the Institute of Chartered Accountants of India. He is working as Senior Manager in I.P. Pasricha & Co., New Delhi. He has post qualification experience of 2 years in the area of taxation advisory and regulatory services.
Poorvi Jain: Senior Executive, I. P. Pasricha & Co., New Delhi
Poorvi Jain is working with I. P. Pasricha & Co. as Senior Executive in Direct Taxation. She has done her articleship from Lodha & Co., New Delhi and gained experience in assessments/ transfer pricing assessments, returns filings, drafting opinions, preparation of Transfer Pricing Study reports.
Disclaimer: Above expressed are the personal views of the author, and the publisher or the author disclaim all, and any liability and responsibility, to any person on any action taken on reliance of it.
 (1997) 65 CCH 0523 ISCC : (1997) 227 ITR 172 (SC)
 (2016) 95 CCH 0004 DelHC : (2016) 66 taxmann.com 178 (Delhi)
 (2015) 44 CCH 0427 AhdTrib : (2015) 155 ITD 0239 (Ahmedabad)
 (2009) 77 CCH 0218 DelHC :  181 Taxman 249 (Delhi)
 (1938) 6 CCH 0001 AllHC : (1938) 6 ITR 157
 (1998) 66 CCH 1294 ISCC : 236 ITR 315 (SC)
 (1998) 66 CCH 1294 ISCC : 236 ITR 315 (SC)
 (1997) 65 CCH 0523 ISCC :  93 Taxman 502 Supreme Court
 (1970) 38 CCH 0026 CA :  77 ITR 857, 860
- CASH PAYMENT
I. Background Recently, th...
- LOAN WAIVER
Business houses in today&rs...
In a recent judgment, the B...
- BUSINESS RESTRUCTURING
With technology blurring th...
- DEPRECIATION ON GOODWILL PURSUANT TO MERGER
Introduction Typically, mer...
- FAIR MARKET VALUE OF UNQUOTED SHARES
Background Finance Act 2017...
- CROSS BORDER MERGERS IN INDIA A STEP TOWARDS GLOBALISATION
With globalisation of the w...
- DIRECT TAX CODE
On November 22, 2017...
- CAPITAL GAINS RELIEF UNDER INDIA-MAURITIUS TAX TREATY
Introduction Recently Slov...
- ANTI-ABUSE PROVISIONS IN TAX TREATIES
Introduction On March 19, 2...