1. Introduction :-It is quite common among the businessmen involved in a manufacturing activity to carry out replacement of parts or machines in a production system. The very word ‘replacement’ would only refer to a situation where it would mean that an existing facility is maintained at its level of efficiency. In other words, such replacement of parts or machines would not result in enhancement of production capacity. Whether such replacement cost is to be treated as revenue or capital expenditure is always a controversial issue.
It is quite common for the Revenue to treat such expenditure as capital in nature and administer depreciation allowance, only. An assessee would always put forth his argument that such replacement cost is only to maintain the existing level of efficiency of his manufacturing facility and would not result in any increase in its production capacity, thereby claiming it to be revenue in nature. In this context, it is quite pertinent to examine the current judicial thinking on this issue.
2. Judicial precedence :-This issue came up before the Hon’ble Madras High Court in the case of CIT vs. Janakiram Mills Ltd. (2005) 275 ITR 403, Mad. It was held by the Court that even replacement of core machinery when it forms part of the continuous process industry, the same is to be allowed as revenue expenditure. The block of assets system should make no difference with this inference. It was held that though such replacement costs may be qualified as current repairs u/s 31, the same would be equally eligible for deduction u/s. 37 of the Act. The Court distinguished earlier Supreme Court Ruling in Ballimal Naval Kishore vs. CIT (1997) 224 ITR 414 and clarified that the Apex Court judgment applies only to cases of replacement of ‘entire manufacturing facility’. It was observed that the Courts cannot ignore the advancement in science and technology and accordingly, identify the thin line of demarcation between capital and revenue expenditure.
2.1 It is important to distinguish between what is ‘current repairs’ and what is an ‘item of expenditure’ allowable u/s 37 of the Act. Finance Act, 2003 amended sections 30 and 31 relating to deductions for repairs of buildings and machinery, plant & furniture to provide that current repairs shall not include any expenditure in the nature of capital expenditure. The words ‘current repairs’ and ‘capital expenditure’ are contradicting terms. In view of the same, it was widely debated among the professional circles whether the Explanations have served any additional purpose. In other words, even in the absence of the Explanations bringing out the amendment to sections 30 & 31, the import of contradiction was intact. Accordingly, it was also felt that the amendment did not bring in any new ratio and thereby, the plethora of case law in this context was intact for reliance. It is appropriate to discuss the characteristic of enduring nature in respect of particular expenditure to decide whether the same is capital or revenue.
2.2 Landmark judgment of the Apex Court in Empire Jute Co. Ltd. vs. CIT (1980) 124 ITR 1 is of immediate relevance in this context. It was categorically held that every enduring advantage may not result in capital asset and if the same is not capital asset, the relating expenditure is to be allowed in the revenue field. If the enduring advantage resulting in expenditure, allows an assessee to carry on business smoothly in an efficient manner, the same cannot be said to have created a new asset. Accordingly, the ratio to be applied as mentioned above would hold good irrespective of the volume of expenditure. In appreciating whether a new asset has been created, it is directly relevant to verify whether the expenditure resulted in increasing the production capacity of the assessee.
2.3 The guidelines laid down by the Supreme Court in Alembic Chemical Works Co. Ltd. vs. CIT (1989)177 ITR 377 are of absolute relevance which provided that the test of ‘manufacturing capacity increase’ is to be carried out for identifying capital expenditure. Relying on this ratio, cost of installation of Water Treatment Plant and Fume Extraction Plant which resulted in improvement of operations of existing systems with greater efficiency in avoiding health hazards etc. and also complying with statutory requirements was allowed only as revenue expenditure, as the same did not increase the productive capacity in any manner — CIT vs. Steel Complex Ltd. (1999) 238 ITR 1054, (Ker).
2.4 Having discussed the prerequisite criteria for allowance of expenditure as a revenue item, it is critical to look at what is allowable as current repairs u/s. 31. If a claim is made u/s 31, then an assessee needs to ensure that his claim fits within the framework of the existing provisions of sec. 31. Although, such a claim, if not allowed u/s 31, can still be entertained u/s 37, is secondary when the claim is confined to sec. 31. ln Janakiram Mills case (supra) replacement of whole machinery which formed part of continuous process industry was allowed as revenue expenditure. In other words, all machines involved in the process are treated as one plant. The Hon’ble Madras High Court while allowing the expenditure u/s 31 also approved the same as allowable u/s 37 of the Act. It is in this context, one needs to appreciate whether an assessee’s of claim u/s 31 would be supported by a standby claim u/s 37 though not apparently claimed by the assessee. Subsequent developments in the judicial thinking as per Apex Court’s judgments are of immediate importance in this context
3. CIT vs. Saravana Spinning Mills (2007) 292 ITR 201 :- The issue regarding replacement cost of ring frames which had worn out in a textile mill as current repairs u/s 31(i) came up before the Hon’ble Supreme Court. Assessee claimed the whole textile mill as a plant and the ring frames were one of the 25 machines which constituted one single process. Replacement of ring frames was treated by the assessee as replacement of old parts which had become derelict. After Assessing Officer rejected assessee’s contention, all Appellate Authorities from ClT(A) to the High Court approved assessee’s claim by holding that process of converting cotton into yarn was continuous interlinked process. It was also observed that the ring frames could not work independently and could work as a part of single unit and allowed expenditure as deductible u/s 31(i) of the Act.
3.1 On an appeal by the Revenue, the Hon’ble Supreme Court rejected the contention of the assessee that the manufacturing process in the textile mill as one continuous integrated process. Certificate issued by South India Textile Research Association (SITRA) has been ignored. It was held that to allow deduction u/s 31(i), the test was not whether the expenditure was revenue or capital in nature, but whether the expenditure was current repairs. Each ring frame was identified as a separate functional machine and the s.e. rejected the expenditure as current repairs. The issue was not dealt with from the context of sec. 37 at all. In other words, whether the expenditure is capital or revenue has not been dealt with and only the simple question whether expenditure is to be treated as current repairs alone has been answered. It was held that the expenditure under question was not to be treated as current repairs. It was observed even if the expenditure is revenue in nature, it may not fall in the connotation of current repairs.
3.2 While holding the above position. it was held by the Apex Court that decision of Janakiram Mills (supra) of Madras High Court has been reversed. It was also observed that its own earlier judgments in New Shorrock Spinning and Mfg. Co. Ltd. vs. CIT (1956) 030 ITR 038 (Bom) and CIT vs. Mahalakshmi Textile Mills Ltd. (1967) 066 ITR 0710 (SC) have been distinguished and continued to be good law.
3.3 CIT vs. Ramaraju Surgical Cotton Mills (2007) 294 ITR 328 : In another judgment of the Apex Court, the issue of the replacement cost of assets without increase in production capacity was dealt with under the context of sec. 37 of the Act. It was observed by the Apex Court that Madras High Court Judgment in Janakiram Mills has been set aside by the same Court in Saravana Spinning Mills case (supra). It is done as there was confusion between the tests to be applied in respect of sec. 31 vis-a-vis the case of sec. 37 of the Act. Without expressing any opinion, the Court remanded the matter to Commissioner (Appeals) for fresh examination of the tenability of assessee’s claim. Mutual claims made by the Assessee and the Revenue were not addressed by the Court and Commissioner (Appeals) was directed to examine the matter uninfluenced by any observations made by the High Court in this case. Both the Assessee and the Revenue were given liberty to adduce additional evidences before the Commissioner.
3.4 Summing up the ratio laid down by both the above Apex Court’s judgments, it is to be analyzed as under:
- Saravana Mills case is solely on the issue of current repairs u/s 31(i) and allowability u/s 37 was not under discussion at all. In other words, the expenditure under question was not dealt with from the context of capital or revenue.
- Textile Mill was not accepted as a single process industry.
- Earlier judgments of Apex Court in New Shorrock Spinning (supra) and Mahalakshmi Mills (supra) have remained intact and the present Ruling is distinguished from those cases
- Increase in production capacity as a prerequisite criteria for treating expenditure outlay as capital in nature, remains intact and the present Ruling does not touch upon the same.
- It is evident from the judgment of Saravana Mills case that every revenue expenditure relating to repairs/replacements may not fit into the framework of current repairs u/s 31(i) of the Act.
- In Ramaraju Surgical’s case nothing has been decided and the matter was remanded to Commissioner for fresh examination in an uninfluenced manner considering respective claims of both the Revenue and the Assessee the context of sec. 37 of the Act.
- It is to be noted that Janakiram Mills case (supra) of Madras High Court has been reversed by the Apex Court and is no more a good law.
3.5 In the advent of these RuIings and the above analysis of the judgments, it is to be appreciated that a genuine revenue expenditure is not hit by the Apex Court Rulings. It is only the scope of ‘current repairs’ u/s 31(i) has been clarified. It is to be further appreciated that the plethora of case law decided in the context of repairs/replacements of machinery with respect to deductibility u/s 37 has been unaffected.
4. Conclusion:- An assessee is legally entitled to appraise the Revenue of the true import of Saravana Mill’s case, if an ad hoc approach of rejecting every repair / replacement expenditure as deductible expenditure is adopted by the Revenue. In the same breath every assessee is expected to understand the scope of the current repairs u/s 31(i) of the Act, in the advent of these Rulings. The unending controversy of capital and revenue expenditure attained a new dimension under the recent judicial trends.