Capital or revenue expenditure – Replacement of machinery in a spinning mill is not revenue expenditure.

Entries in the book of accounts may not be determinative as
to the nature of expenditure but were indicative of what the assessee himself
thinks of the expenditure.

The respondent assessee was engaged in the manufacture and
sale of cotton yarn. During the assessment year 1995-96, the assessee claimed an
amount of

Rs.61, 28,150 as being expenditure incurred on replacement of
machinery as revenue expenditure. The assessee believed that such expenditure
was merely expenditure on replacement of spare parts in the spinning mill system
and, therefore, amounted to revenue expenditure. The Assessing Officer (AO) did
not, however, accept this view of the assessee. According to him, each machine
in a spinning mill performs a different function and the product from one
machine is taken and manually fed into another machine and the output obtained.
All the machines are thus not integrally connected. Based on this reasoning, the
Assessing Officer disallowed the above claim of the assessee and held the said
expenditure to be of a capital nature. The AO further held that the assessee had
treated the said expenditure as capital expenditure by capitalizing the assets
in the books of account and had, thus, shown profit in its profit and loss
account to third parties like bankers, financial institutions, creditors,
shareholders, etc. However, from the tax point of view, the respondent wanted to
reduce the net profit and the total taxable income by claiming such huge
expenditure in the statement of total income computation for acquisition of
fixed assets as revenue expenditure. The AO further held that the assessee could
claim depreciation on the said assets as per Income-tax Rules.

On an appeal, the Commissioner of Income Tax (Appeals)
allowed the appeal of the assessee, inter alia, holding that the replacement of
machinery by the assessee in this case constituted revenue expenditure.

On appeal by the Revenue, the Tribunal followed the decision
of the Madras High Court wherein it was decided that replacement of the ring
frame constitutes only replacement of a part of the machinery in textile mills.
The Tribunal thus upheld the order of the Commissioner of Income-tax (Appeals)
and dismissed the appeal of the Revenue.

The High Court, relying on its own decision in CIT vs.
Janakiram Mills Ltd. [2005] 275 ITR 403 (Mad) and CIT vs. Loyal Textile Mills
Ltd. [2006] 284 ITR 658 (Mad), dismissed the appeal filed by the Revenue and
held that the expenditure on replacement of machinery was revenue in nature. The
High Court further held that the question whether the expenditure on replacement
of machinery was capital or revenue in nature was not determined by the
treatment given to it by the assessee in the books of account or in the
balance-sheet. The claim had to be determined only by relying on the provisions
of the Act and not by the accounting practice followed by the assessee.

On further appeal, the Supreme Court observed that the first
issue was whether each machine in a textile mill is an independent item or
merely a part of a complete spinning textile mill, which only together are
capable of manufacture — and there is no intermediate product produced.
According to the Supreme Court, this issue had been satisfactorily answered by
its decision in CIT vs. Saravana Spinning Mills P. Ltd. [2007] 293 ITR 21 (SC).
In that case, the court had held unambiguously that “each machine in a segment
of a textile mill has an independent role to play in the mill and the output of
each division is different from the other.” The Supreme Court thus held that
each machine in a textile mill should be treated independently as such and not
as a mere part of an entire composite machinery of the spinning mill. It can at
best be considered part of an integrated manufacture process employed in a
textile mill.

On the issue of “current repairs” under section 31 of the
Act, in CIT vs. Saravana Spinning Mills P. Ltd. (Supra), it has been laid down
that in order to determine whether a particular expenditure amounted to “current
repairs”, the test was “whether the
expenditure was incurred to preserve and maintain”, an already existing asset
and not to bring a new asset into existence or to obtain a new advantage. For
“current repairs” determination, whether the expenditure was “revenue or capital
was not the proper test”.

The Supreme Court held that replacement of such an old
machine with a new one would constitute the bringing into existence of a new
asset in place of the old one and not repair of the old and existing machine.
Thus, replacement of assets as in the instant case could not amount to “current
repairs”, and the expenditure made by the assessee could not be allowed as a
deduction under Section 31 of the Act.

The Supreme Court observed that given that Section 31 of the
Act was not applicable to the said expenditure of the assessee, the next issue
was whether it could be considered “revenue expenditure” of the nature envisaged
under Section 37 of the Act. The Saravana Mills’ case held that the expenditure
was deductible under Section 37 only if it: (a) was not deductible under Section
30-36, (b) was of a revenue nature, (c) was incurred during current accounting
year, and (d) was incurred wholly and exclusively for the purpose of the
business. According to the Supreme Court, the assessee’s expenditure satisfied
requirements (a), (c) and (d) as stated above. The dispute was with respect to
the nature of expenditure, that is, whether it was revenue or capital in nature.
The Supreme Court was of the opinion that the expenditure of the assessee in
this case was capital in nature.

Before concluding, the Supreme Court observed that it was
clear on record that the assessee had sought to treat the said expenditure
differently for the purpose of computing its profit and for the purpose of
payment of income-tax. The said expenditure had been treated as an addition to
existing assets in the former and as revenue expenditure in the latter. Though
accounting practices may not be the best guide in determining the nature of
expenditure, in this case they were indicative of what the assessee itself
thought of the expenditure it made on replacement of machinery, and that the
claim for deduction under the Act was made merely to diminish the tax burden,
and not under belief that it was actually revenue expenditure.