Capital Expenditure v. Revenue Expenditure

Introduction

The expression “capital expenditure” is not defined in the act. The distinction between capital and revenue expenditure is a commercial distinction and must be answered in accordance with sound accounting principles, taking into accounts the facts of the case.

1. Tests for Distinction

The Income-tax Act does not provide for any conclusive or universal test to classify an expenditure into capital expenditure and revenue expenditure. On basis of various courts’ rulings, following instances and the ratio inferred therefrom may be referred to distinguish a capital expenditure from revenue expenditure.

1.1. Whether expenditure provides enduring benefit?

A capital expenditure is closely akin to the concept of securing something which is intended to be of lasting value. Therefore, an expenditure, which brings into existence an asset or advantage of enduring nature, should be regarded on capital account in absence of special circumstances, leading to an opposite conclusion

If an expenditure is incurred with a view to bringing an asset or an advantage of enduring nature into existence, the expenditure is on capital account though the intended asset or advantage may not have been acquired. Thus, a sum spent in trying to procure an agency or a license is capital expenditure though the intended agency or license ultimately may not be secured. Similarly, an expenditure incurred on an unsuccessful attempt to bore a well may be on capital account

1.2. When expenditure is operational or initial?

Initial expenditure incurred for initiating a business or extension of a business is a capital expenditure as it is incurred not for earning profit but for setting-up the profit earning machinery in motion

1.3. Who owns the asset for which expense is incurred?

Expenditure incurred by an assessee on a capital asset belonging to him may be taken on capital account. However, such expenditure may be deductible as revenue expenditure if the asset belongs to a third party. Thus, the contribution made by a sugar mill towards boring of wells and construction of go down on the land belonging to cane growers, were held deductible as revenue expenditure as those were not properties of the assessee but of the cane growers

1.4. Whether asset is fixed or circulating?

Expenditure relating to fixed capital or capital assets is deemed to be on capital account whereas an expenditure relating to circulating capital or stock-in-trade is revenue expenditure. ‘Fixed Capital’ is what the owner retains to earn profit by keeping it in his own possession. Circulating capital is what the owner parts with for making profit

The object, for which an expenditure is incurred, plays a decisive role to classify the expenditure as capital or revenue. If the object of the expenditure is to facilitate the trading operations or enabling the management to carry on the business more efficiently or profitably while leaving the fixed capital untouched, the expenditure would be on revenue account even though the advantage may endure for an indefinite future.

1.5. Whether expense removes the competition?

Any expenditure to culminate the competition in business may be treated as capital expenditure. Thus, any amount paid to a retiring partner for not carrying on a similar business is a capital expenditure

1.6. Whether expense removes defect in title?

Any expenditure incurred to cure the defect in the title of the asset is on capital account. Thus, where an assessee purchases a mill, from one of the co-owners and when the sale agreement was challenged by the other co-owner, he made further payment to him to relinquish his interest in the mill, the sum so paid to the other co-owner is a capital expenditure

1.7. Other Rulings

(a) If foreign currency is held to acquire a capital asset, the loss arising due to fluctuation in foreign exchange rate would be on capital account. However, if foreign exchange is held to acquire stock-in-trade of the business, any loss in foreign exchange is on revenue account and would be deductible in computing business profit

(b) Premium paid to obtain lease of a capital asset is deemed as capital expenditure notwithstanding it is payable in lump-sum or in instalments over the whole period of lease

(c) Expenditure incurred by a company to increase its share capital is a capital expenditure

(d) The Supreme Court

i. First, capital expenditure cannot be attributed to revenue and vice versa.

ii. Secondly, a payment in a lump sum does not necessarily make the payment a capital one. It may still possess revenue character in the same way as a series of payments.

iii. Thirdly, if there is a lump sum payment but there is no possibility of a recurrence, it is probably of a capital nature, though this is by no means a decisive test.

iv. Fourthly, if the payment of a lump sum closes the liability to make repeated and periodic payments in the future, it may generally be regarded as a payment of a revenue character

v. Lastly, if the ownership of the money whether in point of fact or by a resulting trust be still in the taxpayer, then there is acquisition of a capital asset and not an expenditure of a revenue character.

2. Deduction for capital expenditure

As a general rule, a capital expenditure shall not be deductible from the taxable profits of the assessee, unless such expenditure is specifically allowed as deduction. Following capital expenditures have been specifically allowed as deduction under various provisions of the Income-tax Act:

References

CIT v. Finlay 20 ITR 475 (SC)

CIT v. Bazpur Sugar 142 ITR 1; Fancy Corpn. v. CIT 162 ITR 827; Shri Digvijay v. CIT 204 ITR 398

CIT v. Reddy 17 ITR 15; Assam Bengal Cement Company Ltd. v. CIT 27 ITR 34 (SC)

Narain Sing v. CIT 129 ITR 698

John Smith v. Moore 12 TC 266, 282 (HL)

Grover Soap v. CIT 221 ITR 299

Colling v. Joseph 7 ITR 92

V. Jagmohan Rao v. CIT (1970) 75 ITR 373 (SC)

Sutlej v. CIT 116 ITR 1 (SC)

H. Dear and Co. (P.) Ltd. v. CIT 60 ITR 546 (SC)

Punjab SIDC v. CIT 225 ITR 792 (SC)

CIT v. General Insurance Corporation (2006) 156 Taxman 96(SC)

Indian Molasses Co. (P.) Ltd. v. CIT [1959] 37 ITR 66 (SC)

This article is general information and not tax advice. Provisions change. Confirm your position with a qualified professional before acting.