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Total Number of Subscribers: 464 | |
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Date:5th November 2008 |
Compiled by Mr. M. Sathya Kumar | |
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Replacement of Parts, Machines etc., in a production System – Tax Implications
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.
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.
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.
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.
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).
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
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.
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.
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.
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.
Summing up the ratio laid down by both the above Apex Court’s judgments, it is to be analyzed as under:
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.
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.
Source
: March of the profession Souvenir published at the time of
National Tax Conference held at Hyderabad. Page
98
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