Interest paid on loans for acquisition of new machinery before same is first put to use, cannot be claimed as revenue expenditure
FOR the Income Tax Department, the latest ruling of the Larger Bench of the Punjab & Haryana High Court amounts to a big win. And, at the centre of the dispute was whether the interest paid on borrowed capital for purchasing new plant and machinery before the same is put to use is revenue expenditure or to be added to the ‘actual cost’ of the asset? What further complicated the issue was the fact that the assessee was a running company and wanted to set up a new plant by buying new machinery out of borrowed capital. Since the new production plant was mere an extension of the existing business, the assessee treated the interest payment as revenue expenditure. Although to curb tax avoidance the CBDT had inserted explanation 8 to Sec 43(1) vide Finance Act, 1986 w e f April 1, 1974 and also inserted a proviso to Sec 36(1)(iii) vide Finance Act, 2003 to make it clear that no deduction shall be allowed for interest paid, in respect of capital borrowed for acquisition of an asset for extension of existing business or profession (whether capitalized in the books of account or not) and such amount of interest is for the period beginning from the date on which the capital was borrowed for acquisition of the asset till the date on which such asset was first put to use. Given that the laws were so unambiguous and clear what was the actual issue before the Larger Bench? It was the interpretation of the converse whether the law also meant that the interest payment before the capital assets are put to use are to be added to the ‘actual cost’ of the assets or to be allowed as revenue expenditure?
And the Larger Bench has held that a reading of memorandum explaining the amendment to Section 43(1) of the Act by way of insertion of explanation 8 thereto clearly shows that the same was carried out with the object to curb tax avoidance by the assessees by adding the interest paid on the capital borrowed for acquisition of the asset even after the asset had been put to use. The position converse was not required to be mentioned therein simply for the reason that an earlier SC judgment in Challapalli Sugar Limited’s case (2002-TIOL-593- SC-IT) was already holding the field on the issue.
The Bench further observed that even a conjoint reading of Section 36 (1)(iii) as existing prior to the proviso thereto and Section 43(1) explanation 8 clearly shows that any interest paid on the capital borrowed for the acquisition of an asset cannot be allowed as a revenue expenditure. The capital might have been borrowed by an assessee for the purpose of business. However, once it is admitted that a part thereof was used by the assessee for the purpose of acquisition of an asset, which is not in the form of replacement or modernization the interest component thereon upto the date it is first put to use has to be dealt with in terms of provisions of Section 43 (1) explanation 8 as otherwise cost of the asset shown in the balance sheet will not depict its true picture. This is in conformity with law and the accounting principles.
While dealing with the effect of addition of proviso of Section 36(1)(iii) added vide Finance Act 2003, the Bench noted that the import of addition of proviso to Section 36(1)(iii) is that the interest paid on the capital borrowed for the purpose of acquisition of an asset till the date such an asset is first put to use shall not be allowed as deduction. This is borne out as a converse proposition vide explanation 8 to Section 43(1) and a combined reading of Section 36(1)(iii) and Section 43(1) shows that the same is in consonance with the law laid down by the SC in Challapalli Sugar Limited’s case, wherein it is provided that any amount of interest paid on the capital borrowed for the purpose of acquisition of the
asset upto the date it is first put to use is to be added towards the cost of the asset. Though proviso to Section 36(1)(iii) was added vide Finance Act, 2003 but in our opinion the same is merely clarificatory as it has made explicit what was already implicit.
Emphasising the need to adopt a purposive interpretation of Explanation 8 of Section 43(1) the Bench held that interest on the capital borrowed for acquisition of an asset for the period before the asset is first put to use is to be added towards its capital cost and for the period thereafter it is not permitted to be added towards its actual cost. The language of Section 43(1) explanation 8 does not in any manner makes out a distinction in the acquisition of an asset when a new business is being set up or when the expansion is being carried out. In fact, the addition of proviso to Section 36(1)(iii) of the Act is nothing else but clarifying the same underlined object in the scheme of the Act providing for the manner in which such an interest on the capital borrowed is to be dealt with.
Brief facts of the case :
The assessee is a well known yarn manufacturer. It decides to set up a new unit at Baddi in Himachal Pradesh. Since it had borrowed capital for the purchase of the new plant and machinery, it paid interest and upfront fee and treated them as revenue expenditure. Since the new unit was an extension of the existing business, the assessee was under the bona fide belief as per the settled law that such expenditure was nothing but revenue in nature. But the AO disallowed the same as the new unit was yet to go online in terms of production, and the interest payment prior to the start of production cannot be allowed as revenue expenditure in view of Explanation 8 of the Sec 43(1).
However, the CIT(A) and the Tribunal allowed the appeal of the assessee by treating the new unit as an extension of the existing business. Thus the issue went to the High Court which after examining the relevant sections and the arguments of both the parties noted that the expression used in Explanation 8 of Sec 43(1) does not make any distinction whether the asset is acquired by the assessee for setting up of an entirely new business or in the process of expansion of its existing business or industry. It merely provides for determination of actual cost of asset on a date when the asset first is put to use. Unless an asset, which is being acquired, starts generating income, it cannot be said that the same is being used for the purpose of business. Once it is established that interest paid after asset is put to use is not to be included in the actual cost on asset. There would be no alternate but to hold that the interest paid before the asset was first put to use would be included in the actual cost thereof and has to be treated as capital expenditure and not revenue in nature.
However, since another Division Bench of the High Court had held a different view on this issue, the matter was referred to the Chief Justice, and the issue was finally heard by a Larger Bench.
Before the LB, the counsel for the assessee argued that the stand of the revenue is not that a new business was set up. The case of both the parties is that only new unit was set up in the same line of production. Meaning thereby the business remains the same. An additional or a new unit in the same business does not involve fresh computation of profits and gains of business or professional and once the business remains the same, the only conclusion is that whatever cost is incurred the same shall be allowable as revenue expenses. He further submitted that even where a loan or borrowing is utilized to purchase the capital asset or set up new unit, that does not itself mean that the interest thereon till the new asset/new unit comes into production cannot be claimed as deduction.
He further submitted that the only object of the amendment was to restrict the claim of interest on the borrowings for creation of capital assets after the same is first put to use. Such interest was not to form part of the actual cost of the asset. The converse position that for period prior to the asset being first put to use shall form part of the cost of the asset is not provided in the explanation. He further submitted that explanation 8 to Section 43(1) of the Act cannot restrict the scope of Section 36(1)(iii) as Section 43 merely contains definitions, which are limited for grant of depreciation and investment allowance. In fact the position has been made clear by the Legislature itself by adding proviso to Section 36(1)(iii) of the Act which takes care of such a situation and the amendment is w.e.f. April 1, 2004. This clearly means that for the period prior thereto, the position is different. The assessment year involved in the present appeal is 1992-93.
The Bench finally held that,
++ both Section 36 and 43 of the Act form part of the same Chapter, rather the same sub-part thereof dealing with profits and gains of business or profession. Section 43 of the Act contains definitions of certain terms relevant to the determination of income from profits and gains from business or profession. One of the definition in Section 43(1) is of the term “actual cost of the asset”. The dispute in the present case is as to whether the interest paid by the assessee on the loans raised for acquisition of new asset, before the same was first put to use, is to be added towards the cost of the asset or the same is to be granted as a revenue expenditure for the reason that the assessee was already in business. Meaning thereby that in case the claim made by the assessee is accepted and the interest so suffered by the assessee is allowed as a revenue expenditure the same will not be added towards the cost of the asset. Whereas in case the claim of the revenue is accepted, the same would result in addition of the component of interest on the borrowed capital upto the date the asset is first put to use to the cost of the asset, accordingly, Section 43 of the Act cannot be left aside and the claim of the assessee cannot be considered merely by reading one provision of the Act and ignoring the other. The entire scheme of the Act is to be seen and all the provisions of the Act are to be read in conjunction with each other to achieve the underlined object.
++ the object of Income-tax Act is to charge tax on the income earned by an assessee by carrying on his business. The figure so arrived at should not be distorted by any factor. Section 28 provides for charging of income-tax on the profits and gains of business or profession carried on by the assessee under the head “Profits and Gains of Business or Profession”. The business or profession is carried out by an assessee with certain set up. While computing the income under the head “Profits and Gains of Business or Profession” certain deductions have been provided on account of expenses incurred by the assessee for earning such income and certain special deductions for promoting the industrial activities.
Section 36 of the Act provides for certain deductions while computing the income assessable under Section 28 of the Act . Clause (ii) of Section 36 (1) of the Act provides for deduction of the amount of interest paid in respect of capital borrowed for the purpose of business or profession. This, in our view, will not bring within its fold the capital borrowed for the purpose of setting up of a new unit, may be in the same line, as the same would not amount to borrowing capital for the purpose of business or profession but for setting up of a plant, which is not the business of the assessee, rather it is the manufacturing activity. In case the plea raised by the assessee to the effect that the interest paid by it on the capital borrowed for the purpose of setting up of new unit is to be treated as capital borrowed for the purpose of business or profession, the same would result in distortion of the actual profits earned by the assessee in the business already being carried on by it. The new unit set up with the borrowed capital, the interest whereon is sought to be claimed as revenue expenditure, had not yet started contributing to the business carried on by the assessee. It is only when an asset is first put to use and commercial production starts then it starts generating income and it would be in the fitness of things in case the interest on the capital borrowed for the purpose of acquisition of that asset is allowed as a revenue expenditure only when such asset starts yielding income and not for any period prior thereto. For the period prior thereto the same has to be capitalised.
Thus, the case was decided in favour of the Revenue and against the assessee.