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September 22, 2020

Expenses incurred on upgradation and development of a product is a capital expenditure – Karnataka HC

by CA Shivam Jaiswal in Income Tax, Legal Court Judgement

Expenses incurred on upgradation and development of a product is a capital expenditure – Karnataka HC

While computing the income of an assessee, there are certain expenditures which are disallowed. This means that the income tax department does not allow the benefit of such expenditures and the assesses are required to pay taxes on such expenditures by adding it back to the net profits. Expenses which are allowed as a deduction while computing Profits or Gains from Business or Profession ae covered from Section 28 to 37 of the Income Tax Act.

As per Section 37(1) of the Income Tax Act, Any expenditure (not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”.

Let us refer to the case of Bioplus Life Sciences Pvt Ltd Vs DCIT (Karnataka High Court) where the issue under consideration was whether appellant was entitled to claim deduction of the expenditure incurred towards upgrading and development of a product as revenue expenditure (allowable under Income Tax) or was the same to be treated as capital expenditure (disallowable under Income Tax)

Facts of the Case:

  • The assessee was engaged in the business of manufacture and export of pharmaceuticals and neutralceutical products.
  • The assessee was carrying on the business in two units viz., Hoodi Unit and Hosur Unit.
  • During the AY’s 2006-07 and 2007-08, the assessee developed a product named as ‘SUCRALOSE’ in its unit at Hosur.
  • The assessee claimed deduction under Section 10B in respect of Hoodi Unit and deduction of expenditure under Section 37(1) in respect of the product developed in Hosur Unit.

Assessment Proceedings

  • The AO in respect of AY’s 2006-07 and 2007-08 held that from profit and loss account of the Hosur Unit of the assessee it was noticed that revenues were earned by the aforesaid Unit from a product called ‘GLUCOSAMINE CHLORIDE’, whereas, project development expenses related to development of product ‘SUCRALOSE’.
  • It was further held that the assessee itself in the books of account had capitalized the expenses. However, for income tax purposes it was claimed as revenue expenditure.
  • It was further held that in pharmaceutical company, the formula which was developed would be an asset and using the formula different formulations like tablets, capsules etc are produced commercially.
  • It was also held that the expenses incurred for developing the formula, which gave enduring benefits had to be considered as capital in nature.

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Order of CIT(A) and ITAT

  • The Commissioner of Income Tax (Appeals) affirmed the order passed by the AO and dismissed the appeals.
  • The assessee thereupon approached the Income Tax Appellate Tribunal (ITAT).
  • The ITAT held that assessee by manufacturing the new product viz., ‘SUCRALOSE’ has obtained an enduring benefit and the assessee itself had capitalized the expenditure in the Books of accounts.
  • The appeals preferred by the assessee were partly allowed.
  • Being aggrieved, the assessee appealed before the High Court.

Appeal before the High Court (HC) was raised on the following questions of law:

  • Whether the ITAT was justified in holding that manufacturing and administrative expenses incurred by the appellant for development of a product in the course of its manufacturing activity which was already carried on, was capital expenditure?
  • Whether the appellant was entitled to claim deduction of the expenditure incurred towards upgrading and development of a product as revenue expenditure under Section 37(1) and whether the ITAT was justified in holding that the expenditure incurred towards upgraded and development of a product was to be considered as capital expenditure?
  • Whether the ITAT was justified in holding that sucralose was entirely a new product different from the products, which were manufactured currently and exported by the appellant company?

Reference by the High Court (HC) to earlier cases

  • The HC found it appropriate to take note of well settled legal principles to determine whether expenditure of the assessee was a capital expenditure or a revenue expenditure.
  • The Supreme Court in ‘Alembic Chemical Works Co Ltd vs CIT’ had laid down the following principles:
  • When an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of trade, such expenditure should be treated as properly attributable not to revenue but to capital (in the absence of special circumstances leading to an opposite conclusion)
  • If the expenditure is made for acquiring or bringing into existence an asset or advantage for the enduring benefit of the business it is properly attributable to capital and is of the nature of capital expenditure.
  • If on the other hand it is made not for the purpose of bringing into existence any such asset or advantage but for running the business or working it with a view to produce the profits, it is a revenue expenditure.
  • The aim and object of the expenditure would determine the character of the expenditure whether it is a capital expenditure or a revenue expenditure.
  • The aforesaid principles were quoted with approval in Honda Siel Cars India Ltd supra and it was held that primary test, which was to be adopted with reference to acquisition of technical information and know how, remained the same, viz., the enduring nature test.
  • It was further held that where the expenditure was incurred which gave enduring benefit, it would be treated as capital expenditure and technical information and know how were intangible assets. So, the same had to be treated as capital expenditure.

Observations of the High Court (HC) on whether the expenditure was capital or revenue in nature?

  • It was pertinent to note that assessee had started a new Unit at Hosur in 2004-05 by taking over machineries and properties of M/s V B Medicare Pvt Ltd on lease.
  • The work of development of ‘SUCRALOSE’ viz., a new product was started in 2005-06 in Hosur Unit.
  • The product was developed in 2006-07. Thus, the assessee had produced a new product from which enduring benefit was derived.
  • Therefore, the same had to be treated as a capital expenditure.
  • An asset was brought into existence for enduring benefit of the business and therefore, the same had to be treated as capital expenditure.
  • The expenditure had not been made for bringing into existence an asset for running of the business or working with it with a view to produce profits.
  • Therefore, the same cannot be treated as revenue expenditure.
  • The assessee himself in the Books of account had shown it as capital expenditure.
  • Therefore, the AO, the CIT (A) and the ITAT had rightly treated the expenditure incurred by the assessee for development of a new asset as capital expenditure.

In conclusion, if an expenditure is incurred for bringing into existence an asset, the same is to be treated as capital expenditure and hence will be disallowed under the Income Tax provisions.

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