Replacement of Machinery Giving Enduring Benefit Is Capital Expenditure: Madras HC

Hon’ble High Court holds that replacement of machinery resulting in enduring benefit amounts to capital expenditure, not revenue expenditure

Summary: The Income Tax Appellate Tribunal had allowed the assessee’s claim treating expenditure on replacement of machinery as revenue expenditure under “current repairs.” However, the High Court found that the Tribunal relied solely on a precedent that was subsequently overruled by the Supreme Court. The Madras Court observed that each machine in a textile unit is an independent entity and not part of a single composite system, and replacement of such machinery results in bringing into existence a new asset or advantage. It held that such expenditure is capital in nature and only eligible for depreciation under Section 32, unless it qualifies strictly as “current repairs.” The Court emphasized that large-scale replacement as part of modernization cannot be treated as revenue expenditure. Since the Tribunal failed to undertake independent analysis and relied on an overruled judgment, its order was set aside, and the matter was remanded for fresh consideration in accordance with settled legal principles.

Facts:

• The assessee, M/s. Super Spinning Mills Ltd., engaged in the manufacture and sale of cotton/blended yarn, filed its return of income on 27.11.1996 for the Assessment Year 1996-97 declaring an income of Rs. 6,03,371, which was subjected to scrutiny under Section 143(3) of the Income Tax Act. The assessee claimed a sum of Rs. 6,19,43,673 incurred towards replacement of machinery as revenue expenditure. However, the Assessing Officer rejected the claim on the ground that the machinery replaced were independent, sophisticated and modern machinery capable of delivering higher production and quality, and therefore the expenditure was capital in nature, though depreciation at the rate of 12.5% was allowed.
• On appeal, the Commissioner of Income Tax (Appeals) partly allowed the claim only in respect of certain items of spare parts which were satisfactorily explained as replacements to existing machinery and not substitutes for new machinery.
• Similarly, for Assessment Year 1997-98, the assessee claimed Rs. 13,10,00,563 towards replacement of plant and machinery as revenue expenditure, which was disallowed by the Assessing Officer and treated as capital expenditure with depreciation allowed. The appeal before the CIT(A) was dismissed following the earlier order for Assessment Year 1996-97.
• The assessee as well as the Revenue filed appeals before the Income Tax Appellate Tribunal, which were heard together and disposed of by a common order dated 26.07.2005. The Tribunal allowed the claim of the assessee by relying on the decision of the Hon’ble Madras High Court in CIT vs. Janakiraman Mills Ltd. (275 ITR 403), holding that expenditure on replacement of worn-out machinery could be treated as revenue expenditure under current repairs.
• Aggrieved by the order of the ITAT treating such expenditure as revenue expenditure, the Revenue preferred the present appeals before the Hon’ble High Court.

Issues:

• Whether the replacement of machinery parts will amount to revenue expenditure or not?
• Whether bringing into existence of a new asset or obtaining a new advantage would amount to revenue expenditure or not?

Observations:

• The Hon’ble High Court, before addressing the substantial questions of law, examined in detail the reasoning adopted by the Assessing Officer. It noted that the Assessing Officer had analysed the nature of machinery used in the manufacture of yarn and observed that though the various machines may be interdependent, each machinery performs a distinct function and operates independently. It was emphasized that each machinery is not part of a single composite machine but is a separate unit capable of independent functioning. In this context, reliance was placed on Aruna Mills Ltd. vs. Commissioner of Income Tax, Ahmedabad, wherein the Hon’ble Gujarat High Court, following the decision of the Hon’ble Supreme Court in CIT vs. Mir Mohd. Ali (53 ITR 165) and the Privy Council in Corporation of Calcutta vs. Chairman, Cossipore and Chitpore Municipality, explained the meaning of “machinery” as independent mechanical contrivances. The Hon’ble Court also noted that the assessee had shown such replacements as additions to assets in its balance sheet, indicating that the expenditure was for installation of new machinery rather than repair of existing ones. It was further observed that the Act does not provide any provision allowing deduction of cost of plant and machinery merely on the ground that it replaces existing machinery, and that under the scheme of Section 32, only depreciation is allowable in such cases. The Assessing Officer also relied upon CIT vs. Southern Petro Chemical Industries Corporation Ltd. (No.2) (233 ITR 400) to hold that the assessee has no option to choose between claiming depreciation and treating such expenditure as revenue.
• The Hon’ble Court then examined the reasoning of the Commissioner of Income Tax (Appeals), who had affirmed the view of the Assessing Officer. The Appellate Authority observed that the assessee had undertaken replacement of machinery as part of a systematic programme of modernization involving substantial expenditure over a period of time. It held that replacement of independent machinery could not be treated as revenue expenditure. The contention of the assessee that the machinery formed part of an integrated system was rejected on the ground that each machine functioned independently and had its own capacity, and that replacement involving substantial expenditure would necessarily improve efficiency and functioning. However, the CIT(A) distinguished cases where only spare parts were replaced due to wear and tear and directed verification in such cases for allowing the claim.
• The Hon’ble High Court then turned to the order of the Income Tax Appellate Tribunal and observed that the Tribunal had allowed the claim of the assessee solely on the ground that the issue stood covered by the decision of the jurisdictional High Court in Commissioner of Income Tax (Revenue) vs. Janakiraman Mills Ltd. (2005) 275 ITR 403 (Mad). The Tribunal held that replacement of worn-out machinery could be treated as expenditure under “current repairs” and allowable as revenue expenditure, without undertaking any independent analysis.
• However, the Hon’ble High Court noted that the judgment in Janakiraman Mills Ltd., which formed the sole basis of the Tribunal’s decision, had subsequently been reversed by the Hon’ble Supreme Court in Commissioner of Income Tax vs. Saravana Spinning Mills (P) Ltd. [2007] 293 ITR 201 (SC) and also referred to in Commissioner of Income Tax vs. Ramaraju Surgical Cotton Mills [2008] 166 Taxman 356 (SC). The Hon’ble Court held that once the very basis of the Tribunal’s decision stood overruled, the order could not be sustained.
• The Hon’ble Court further observed that among the various judgments cited, the most appropriate and relevant precedent was the decision of the same Hon’ble High Court in Super Spinning Mills Ltd. vs. Assistant Commissioner of Income Tax, Company Circle-1(2), Coimbatore (2013) 37 Taxmann.com 290 (Mad), as it dealt with the identical issue concerning the same assessee.
• The Hon’ble Court also emphasized that the ITAT had allowed the claim without any independent reasoning and solely on the basis of a precedent which had subsequently been overruled. It was therefore held that on this ground alone, the appeals deserved to be allowed.
• The Hon’ble High Court then examined the legal test for determining whether expenditure on replacement of machinery is capital or revenue in nature. Referring to the judgments of the Hon’ble Supreme Court in Commissioner of Income Tax vs. Sri Mangayarkarasi Mills (P) Ltd. (2009) 182 Taxman 141 (SC) and Saravana Spinning Mills (P) Ltd., the Court observed that machinery in a textile mill cannot be treated as a single composite asset and that each machine is an independent entity forming part of the production process. It was further held that replacement of such machinery would not automatically qualify as “current repairs.” The Court also referred to Commissioner of Income Tax vs. Mahalakshmi Textile Mills Ltd. (1967) 66 ITR 710 (SC) to note that to fall within the ambit of current repairs, the assessee must establish that the old parts were not available in the market or that they had been used for a long duration.
• In light of the above, the Hon’ble High Court held that the order of the ITAT, which was based on a judgment subsequently overruled, could not be sustained. The Court found that the decision in Super Spinning Mills Ltd. (2013) squarely applied to the present case. Accordingly, the orders passed by the ITAT were set aside and the matter was remanded to the Appellate Authority for fresh hearing, directing it to afford an opportunity to the assessee to place necessary materials and to decide the issue in the light of the principles laid down by the Hon’ble Supreme Court and the High Court. Finally, the Hon’ble High Court disposed of the appeals on the above terms.