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George Cheriyan, Accountant Member
1. This appeal is by the assessee and relates to the assessment year 1977-78.
2. The assessee is a company. The company was incorporated on 29-7-1974 and the main objects of the company were to own and acquire ferrous and non-ferrous metal, melting furnaces, rolling mills and carry on business as traders and manufacturers of ferrous and non-ferrous metal ingots, etc. and to do business of traders or manufacturers of steel products and hardware of all kinds, as also to deal in iron, steel and other metals and minerals and to act as stockists, commission agents, etc., for engineering industrial requirements.
3. The balance sheet as at 30-6-1976, i.e., incorporating the results for the period 1-7-1975 to 30-6-1976, contained an item, ‘Miscellaneous expenditure not yet adjusted : Rs. 29,93,636’. The details according to the balance sheet, were contained in Schedule ‘E’. Schedule ‘E’ gave the expenditure incurred right from 29-7-1974, i.e., the date of incorporation, to 30-6-1976 and which remained unadjusted. These details were given in Annexure which formed part of the balance sheet as at 30-6-1976. The aggregate unadjusted expenditure came to Rs. 30,13,628 which included the opening balance, as on 1-7-1975 of Rs. 7,87,256. Against the amount of Rs. 30,13,628 in the Annexure, two items were shown as deductions, viz., Miscellaneous receipts : Rs. 4,900 and Interest received : Rs. 15,092 arriving at a net balance of Rs. 29,93,636.
4. The assessee, in filing the return for the assessment year 1977-78, showed the total income at nil and gave an accompanying computation as under:
Income from business : The company is still under construction stage and has yet to commence production. The expenses incurred during construction period, pending allocation to capital account, are detailed in the notes attached to the balance sheet as at 30-6-1976.
The interest income received by the company is being treated as part of the business income, pursuant to one of the objects for which the company is established. Since it is being treated as business income, a portion of the expenditure incurred has to be deducted from this income. Therefore, nil income is being returned under this head :
Rs. Rs. a. Interest received as detailed in Schedule 'E' of balance sheet 15,092 b. Other miscellaneous receipts 4,900 (-) 19,992 Expenses apportionable 30,13,628 _____________ Balance to be capitalised 29,93,636 _____________ Total income Nil __________
In the background of the aforesaid claim, the ITO observed that the contention of the assessee that the receipt should be treated as business income and expenditure incurred had to be set off against the income could not be accepted. He observed that interest receipts and other income had to be taxed separately inasmuch as expenditure incurred was for the purpose of construction work only and was for the purpose of earning income assessable under the head ‘Income from other sources’. The ITO concluded in his assessment order that no expenditure could be allowed as a deduction under Section 57 of the Income-tax Act, 1961 and the entire receipts of Rs. 19,990 would be assessable. He accordingly computed the total income at Rs. 19,990 and levied tax thereon.
5. The assessee appealed to the Commissioner (Appeals). The Commissioner reiterated that the assessee’s business activity had not yet started and the income received from out of interest on fixed deposits and other incidental activities during the course of construction and erection of factory was assessable under Section 56 as income from other sources. According to the provisions of Section 57(iii), the Commissioner stated, only such expenditure as was laid out or expended wholly and exclusively for the purpose of making or earning such income would be admissible as a deduction and as practically the entire expenditure had been incurred during the course of erection of factory, the Commissioner went on to state, such expenditure require to be capitalised and, as such, the capital expenditure could not be allowed as a deduction, from out of income of the assessee from other sources. In any event, he stated only such expenditure as was wholly and exclusively necessary for making or earning the income could be allowed as a deduction and unless a nexus was established between the expenditure incurred and earning of income, no deduction was permissible. Even so, considering the fact that the assessee required establishment, etc., to be maintained and some expenditure was necessary to earn the income, he allowed a deduction in round figures of Rs. 4,000. Thus, the income stood computed at Rs. 15,990.
6. The assessee appealed to the Tribunal and it was contended in the grounds of appeal that the Commissioner (Appeals) erred in treating the interest earned as assessable under Section 57. According to the assessee, the Commissioner failed to note that the money invested in deposits was out of borrowed funds of the business on which the assessee was obliged to pay much higher rates and there was, therefore, a nexus between interest earned and interest paid and consequently, it was pleaded, appropriate relief may be allowed.
7. When this appeal came up for hearing, the members constituting the Bench were of the view that the matter should be placed before the President of the Tribunal with the request that a Special Bench should be convened, stating that in IT Appeal No. 1692 (Hyd.) of 1979, dated 15-9-1980 in the case of East Coast Salt & Chemicals Ltd., for the assessment year 1977-78, the Tribunal had upheld the contention of the assessee in that case that interest received by a company prior to the commencement of business should be set off against the interest paid by it on its borrowals, but there was a contrary decision in IT Appeal No. 464 (Hyd.) of 1980 dated 3-1-1981 in the case of Andhra Pradesh Carbides Ltd., where a similar contention was not accepted. The Bench considered, therefore, that in view of the two aforesaid decisions, it was necessary to constitute a Special Bench. The President of the Appellate Tribunal has accordingly constituted this Special Bench to hear the case.
8. The learned counsel for the assessee took us through the order of the Tribunal in IT Appeal No., 1692 (Hyd.) of 1979 on which he placed reliance. In that case the assessee had not commenced business and had received interest amount of Rs. 28,161. Interest payment was Rs. 25,000. This was on borrowings of Rs. 2,00,000. The interest receipts were on short-term deposits of Rs. 9,00,000 out of which Rs. 8,00,000 represented share capital and Rs. 1,00,000 borrowings by the assessee. The ITO, therefore, considered that only the interest attributable to the borrowings of Rs. 1,00,000 was to be adjusted and he allowed deduction of Rs. 12,500. The Commissioner (Appeals) agreed with the ITO and the matter was taken to the Tribunal. It was contended before the Tribunal that it was an accepted principle that interest paid by an assessee during construction stage would be capitalised and allocated to the respective assets. Such was the decision of the Supreme Court in Challapalli Sugars Ltd. v. CIT  98 ITR 167. Therefore, the plea was that the interest received should be adjusted to reduce the allocable addition to the cost of assets. In other words, the plea was that when there was both interest received and interest paid, only the net amount should be taken and it resolved to allocate the excess of expenditure alone to the assets. This plea was opposed on behalf of the revenue which placed reliance on the decision of the Calcutta High Court in CIT v. New Central Jute Mills Co. Ltd.  118 ITR 1005. The learned counsel submitted that the Tribunal found that there was considerable force in the contention of the assessee and referring to a decision of the ‘B’ Bench of the Tribunal at Patna in Bihar Alloy Steel Ltd. v. ITO  Taxman 339, agreed with the contention. In this regard he submitted that the Bench considered the principles of accountancy as published in a brochure by the Institute of Chartered Accountants of India on this aspect in coming to the conclusion that it did. According to him, the conclusion arrived at by the Tribunal was unexceptionable.
9. The learned counsel submitted that the facts in IT Appeal No. 464 (Hyd.) of 1980 were distinguishable, because interest receipts in that case were on deposit of share capital and interest payments were on borrowed moneys which were utilised wholly and exclusively for constructing the factory. He also stated that the Tribunal in that case had relied on the decision of the Calcutta High Court in New Central Jute Mills (supra) which was a case where the assessee had claimed the excess payment of interest as a revenue deduction and that in the decision of the Madras High Court in Addl. CIT v. Madras Fertilisers Ltd.  122 ITR 139 the position was similar and hence the ratio of these decisions was also not applicable.
10. Finally, reference was made in extenso to the notes prepared by the Institute of Chartered Accountants of India on ‘Study on expenditure during construction period’, the relevant portions of which read as under:
INCOME DURING THE CONSTRUCTION OR PRE-PRODUCTION PERIOD
8.1 It is possible that a new project may earn some income from miscellaneous sources during its construction or pre-production period. Such income may be earned by way of share transfer fees or by way of interest from the temporary investment of surplus funds prior to their utilisation for capital or other expenditure.
8.2 Where a particular item of miscellaneous income can be directly related to a particular item of expenditure, it is suggested that it would be set off against the expenditure and the net amount of the expenditure should be treated in the appropriate manner, depending upon its nature, in accordance with the various principles suggested above. For example, income from share transfer deed may be set off against the various corporate expenses incurred during the construction or pre-production period and income, if any, from lending transport vehicles to outsiders may be offset against the expenditure incurred in operating and maintaining those vehicles. Similarly, interest income earned during the construction period may be offset against interest expenses incurred during this period.
8.3 Another source of income during the construction or pre-production period relates to the sale of products manufactured during the period of test runs and experimental products. This subject is discussed further in paragraph 11.4 of this note.
11. The learned departmental representative, in reply, contended that as soon as interest accrued, it was income and it had to be considered under what head the income had to be taxed. Where business had not started, obviously the income could be taxed only under the head ‘Income from other sources’. Gross receipts, therefore, from interest had to be considered under the head ‘Income from other sources’ and only such deductions could be allowed as were permissible in computing the income under the head ‘Income from other sources’, i.e., expenditure directly incurred for earning the income under the head ‘Income from other sources’. According to him, therefore, the decision of the Tribunal in IT Appeal No. 464 (Hyd.) of 1980 dated 3-1-1981 clearly laid down the principles which supported his stand and the earlier decision of the Tribunal required reconsideration. On his part, he referred to the following extract from the notes prepared by the Institute of Chartered Accountants of India on ‘Study on expenditure during construction period’:
17.11 During the construction period, a project may earn some income from miscellaneous sources, for example, share transfer fees, interest income, income from hire of equipment or assets and income from sale of products manufactured during the period of test runs and experimental production. It is recommended that such income should be offset against the related item of expenditure so that only the net amount of expenditure is capitalised or treated as deferred revenue expenditure, as the case may be. In either case, consideration may have to be given to the question of providing for the income-tax liability on such income. (Paragraph 8).
With reference to the portion aforesaid on which we have placed emphasis he stated that the Institute itself had pointed out that consideration had to be given to the question of providing for income-tax liability in respect of the income. Therefore, his contention was that the procedure described by the Institute did not militate against his stand, but, on the other hand, supported it.
12. We have considered the rival submissions. In a case like this, we have to first examine the receipts and determine the true nature thereof before proceeding to decide on a claim which may be put forth because the ramifications would be numerous. On the facts, admittedly, in the present case, the interest receipt of Rs. 15,092 is on deposits made from borrowed funds, on which interest was paid by the assessee, which funds were kept’ in such deposits till they were used in the construction work. We find from Schedule E to the balance sheet as at 30-6-1976 that there were interest payments in all to the extent of Rs. 7,94,389 which remained unadjusted. By way of information, we may just mention that the value of buildings under construction as shown in the balance sheet, which represented additions during the year, was of the order of Rs. 28.03 lakhs, additions to plant were to the extent of Rs. 8.32 lakhs and elect]ric installations were of Rs. 4.74 lakhs. It was apparently in this light that in the forwarding note to the return, the assessee had stated that expenditure would have to be capitalised though factually it remained unadjusted in this year as seen from the Schedule. Anyhow, we leave this aspect there because the ITO himself had not pronounced on it. The case of Challapalli Sugars Ltd. (supra) is clear authority for the proposition that interest paid before commencement of production on amount borrowed by the assessee for acquisition and installation of plant and machinery would form part of the ‘actual cost’ of the assets. The relevant observations of the Court in this regard at page 175 of the report are as under :
It would appear from the above that the accepted accountancy rule for determining the cost of fixed assets is to include all expenditure necessary to bring such assets into existence and to put them in working condition. In case money is borrowed by a newly started company which is in the process of constructing and erecting its plant, the interest incurred before the commencement of production on such borrowed money can be capitalised and added to the cost of the fixed assets which have been created as a result of such expenditure. The above rule of accountancy should, in our view, be adopted for determining the actual cost of the assets in the absence of any statutory definition or other indication to the contrary.
What would be the expenditure necessary to bring the assets into existence is a matter of detail again, with which we are not concerned, in the present case, since there is no adjudication on the same by the authorities below. As a general proposition, if in appropriate cases interest incurred before commencement of production on borrowed funds can be capitalised, then, if the assessee can bring about a reduction in the total quantum of expenditure, it would follow that only the lesser amount of interest can be considered for purposes of capitalisation. In the present case, the assessee had borrowed funds. Some of the borrowed funds which were not immediately required were kept by the assessee in deposits and some interest was earned. There was a direct nexus between the borrowed funds and the deposited funds since the deposited funds came out of the borrowed funds. It is, therefore, clear that on the facts of the present case, receipts and payment of interest have to be considered in a single account. Therefore, the receipts of interest would go to reduce the payment of interest. As we have already pointed out, interest payments were to the extent of Rs. 7,94,389 and interest receipts were to the extent of Rs. 15,092. Thus, the amount of interest to be considered for capitalisation purposes would, on the facts of this case, be only the net figures, i.e., Rs. 7,79,297 (Rs. 7,94,389 less Rs. 15,092) because this is the net interest outgoing. Whatever is the interest receipt in the year would be the interest after setting off incomings against outgoings. In this case, there is no positive figure, but an excess interest payment of Rs. 7,79,297 which, according to the assessee, would have to be considered for capitalisation in due course. This is not a case where the assessee claims any net amount as a revenue deduction. Therefore, there is no warrant for holding that the amount of Rs. 15,092 has to be separately considered as interest receipt in its own right in the first instance. This being the case, the question of pigeon-holding (sic) the receipt to determine what would be the outgoings admissible under particular provisions relating to different heads of income under the Income-tax Act does not arise. That being the result, the restrictions in Section 57 regarding admissibility of expenditure have no relevance because we are not considering set off against any amount to be treated as revenue receipt of interest. There is, therefore, no warrant for taxing the amount of Rs. 15,092.
13. Coming to the miscellaneous receipts of Rs. 4,900, we gathered at the hearing that this represented receipts from sale of scrap and articles such as empty cement bags, packing material, etc. Admittedly, cost of cement, etc., would be capital and would go to increase the cost of assets. If any amount is recouped by way of scrap, it would go to diminish the aggregate actual cost. Therefore, on the same analogy, the amount of Rs. 4,900 would not be a separate receipt to be considered for taxation purposes, but would be offset by larger amounts of expenditure of a capital nature and would go to whittle down the capital expenditure which would have to be considered for the purpose of actual cost. There would, therefore, be no warrant for bringing to tax the amount of Rs. 4,900 also in this year.
14. In coming to our conclusion, it would be seen that we have given due regard to the principles laid down in the brochure published by the Institute of Chartered Accountants of India to which we have referred and due importance has also been attached to the question of income-tax liability on which emphasis was placed by the learned departmental representative. On the facts, there is no receipt of income nature which would fall to be taxed and we have held accordingly for the reasons which we have set out in detail. We would, therefore, direct exclusion of the entire amount of Rs. 19,900.
15. The ratio of the judgments of the Madras High Court in Madras Fertilizers Ltd. (supra) and the Calcutta High Court in New Central Jute Mills Co. Ltd. (supra) relied on, on behalf of the revenue, would not also, in the circumstances, apply.
16. The result is, the appeal is allowed.