By TIOL News Service

NEW DELHI, JULY 23, 2009: WHETHER a particular expenditure is revenue or capital in nature is indeed an age-old dispute between the Revenue and the assessee. Although the Apex Court ruling in the case of Saravana Textile Mills Pvt Ltd (2007-TIOL-147-SC-IT) is a landmark decision on this issue but the latest decision goes a step further to obliterate the space of confusion which exists today. In this case the assessee is engaged in the manufacture and sale of cotton yarn. It incurs huge expenditure on replacement of machinery in its plant and claims deduction for the same as revenue expenditure u/s 37. However, the AO disallows it and the same ground has now been upheld by the Supreme Court.

In a very significant ruling the Apex Court Bench has held that each machine in a spinning mill should be treated independently as such and not as a mere part of an entire composite machinery of the spinning mill. It can at best be considered part of an integrated manufacture process employed in a textile mill. Thus the expenditure incurred for reaping long-term and enduring benefits by replacing the independent machine can only be a capital expenditure. The Bench also went on to hold that such expenditure cannot be treated as 'current repairs' u/s 31 as the right test for determining it is whether the expenditure is incurred to `preserve and maintain' an already existing asset and not to bring a new asset into existence or to obtain a new advantage.

The Bench further adds that it is on record that the assessee has sought to treat the said expenditure differently for the purposes of computing its profit and for the purpose of payment of income tax. The said expenditure has been treated as an addition to the existing assets in the former and as revenue expenditure in the latter. Though accounting practices may not be the best guide in determining the nature of expenditure, in this case they are indicative of what the assessee itself thought of the expenditure it made on replacement of machinery and that the claim for deduction under the Act was made merely to diminish the tax burden, and not under the belief that it was actually revenue expenditure.

Facts of the case

The assessee is engaged in the manufacture and sale of cotton yarn. During the assessment year 1995-1996 the assessee claims an amount of Rs. 61,28,150/-, being expenditure incurred on replacement of machinery, as revenue expenditure. The assessee believed that such expenditure was merely expenditure on replacement of spare parts in the spinning mill system and, therefore, amounted to revenue expenditure.

The Assessing Officer (AO) did not, however, accept this view of the assessee because, according to him, each machine in a spinning mill does a different function and the product from one machine is taken and manually fed into another machine and the output is taken, all the machines are, thus, not integrally connected. Based on this reasoning, the AO disallowed the above claim of the assessee and held the said expenditure to be of a capital in nature.

The AO further held that the assessee had treated the said expenditure as capital expenditure by capitalizing the assets in the books of account and had, thus, shown profit in its profit and loss account to third parties, like bankers, financial institutions, creditors, shareholders, etc. However, from the tax point of view, the respondent wanted to reduce the net profit and the total taxable income by claiming such huge expenditure in the statement of total income computation for acquisition of fixed assets, as revenue expenditure. Therefore, he disallowed such expenditure of the assessee to be covered under section 31 of the Act or as revenue expenditure under section 37 of the Act. The AO further held that the assessee could claim depreciation on the said assets as per the income tax rules.

An appeal was preferred by the Respondent against the said order of the AO before the Commissioner of Income Tax (CIT) (Appeals) who allowed the appeal of the assessee, inter alia, holding that replacement of machinery by the assessee in this case constituted revenue expenditure. Tribunal, following the HC decisions, rejected the Revenue's appeal. The HC also rejected the Revenue's plea.

Thus the issue landed before the Apex Court which has now observed that,

++ In Sarvana Textile Mills case (2007-TIOL-147-SC-IT),  the Apex Court has already held that ¶each machine in a segment of a textile mill has an independent role to play in the mill and the output of each division is different from the other.¶ Dealing with a ring frame in a textile mill, this Court has held that it is an ¶independent and separate¶ machine. Further, it is accepted that each machine in a textile mill is part of the integrated process of manufacture of yarn and is integrally connected to the other machines in the mill for production of the final product.

++ However, this interconnection does not take away the independent identity and distinct function of each machine. Thus, each machine in a textile mill should be treated independently as such and not as a mere part of an entire composite machinery of the spinning mill. It can at best be considered part of an integrated manufacture process employed in a textile mill.

++ 'current repairs' under section 31: The decision in Saravana Spinning Mills (P) Ltd. has laid down that in order to determine whether a particular expenditure amounts to `current repairs' the test is ¶whether the expenditure is incurred to `preserve and maintain' an already existing asset and not to bring a new asset into existence or to obtain a new advantage. For `current repairs' determination, whether expenditure is revenue or capital is not the proper test.¶

++ The entire textile mill machinery cannot be regarded as a single asset, replacement of parts of which can be considered to be for mere purpose of `preserving or maintaining' this asset. All machines put together constitute the production process and each separate machine is an independent entity. Replacement of such an old machine with a new one would constitute the bringing into existence of a new asset in place of the old one and not repair of the old and existing machine.

++ Also, a new asset in a textile mill is not only for temporary use. Rather it gives the purchaser an enduring benefit of better and more efficient production over a period of time. Thus, replacement of assets as in the instant case cannot amount to `current repairs'.

And finally, the Bench held that there are sufficient judicial decisions to support the view that such expenditures incurred on replacement of machineries which are independent of an otherwise integrated manufacturing process is capital in nature. And thus the Revenue's appeal allowed.

(See 2009-TIOL-86-SC-IT in 'Income Tax')