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When is a business set up?

T. C. A. Ramanujam

T. C. A. Ramanujam on a AP High Court decision on the question of setting up and commencing a business.

EQUITABLE tax jurisprudence demands a proper grasp of the concept of setting up and commencing a business. When is a business set up? When does it commence? Can it be said that trial production amounts to commencement of regular business? An understanding of the answers to these queries is essential for a successful claim of deductions towards business expenditure, depreciation and Chapter VI A deductions.

It is fundamental to tax law that expenditure incurred prior to the setting up of business cannot be considered for allowance and will be outside the scope of Section 28 of the Income-Tax Act, 1961. Business has to be carried on. Before it can be said to be carried on, it should be set up. When can a business be said to have been set up?

Coramandel Fertilizers was carrying on the business of manufacture and sale of both fertilisers and cement. The company claimed that it had commenced limestone-mining activity for the production of cement in 1982. It claimed the expenditure incurred as a deduction under Section 28 of the I-T Act, 1961. It also claimed depreciation and investment rebate.

The Revenue held that the business was not set up and there was no manufacturing activity of cement. The deduction was refused. As the company had succeeded before the Tribunal, the matter was taken up in appeal before the AP High Court.

The court, in its judgment, drew a distinction between the setting up of business and its commencement. It pointed out that mere setting up of business would entitle the company to deduction of expenditure and depreciation. It is only when the machinery was installed that the business could be said to be put into such a shape that it could start functioning as a manufacturing organisation.

Setting up of business is the culmination of several operations such as purchasing the land, procuring raw materials and obtaining the machinery and equipment. This was the explanation given by the Supreme Court for the expression "set up" in the Ramaraju Surgical Cotton Mills Ltd (63 ITR 478) case, which was one on the Wealth Tax Act.

The AP High Court drew attention to the fact that while quarrying limestone may be an essential aspect of manufacture, the activity of mere quarrying is too remote to be in proximity to the business of manufacture of cement. It was never the case of the company that plant and machinery had been erected within a short time after commencement of the quarrying of the limestone.

A distinction has to be drawn between the preparatory stage comprising acquisition of building, plant and machinery, and so on, and the subsequent activities. Mere acquisition of licence will not amount to commencement of business. It was not shown that Coramandel Fertilizers was in a position to use quarried limestone as raw material for the manufacture of cement. The sole step taken by the company in order to quarry cement would not amount to setting up the business.

This activity of quarrying limestone is not interconnected to the activity of manufacture of cement by the user of plant and machinery set up for the purpose. It should be followed by manufacture and sale. "The business may commence when the activity which is first in point of time and which must necessarily precede the other activities is started provided there is a proximate connection between the activity which is first in point of time and the subsequent activities which go to make up the business. Mere quarrying of limestone in the leased land itself per se would not amount to setting up of business."

The Revenue succeeded in defeating the claim of the company for deduction (128 Taxman 869 AP).

Further, the question of whether a business may be said to have commenced the moment there is trial production may emerge. This issue is important in the context of Chapter VI-A deductions. The production contemplated under Section 80 J, 80 IA or 80 IB is commercial, and not stray or experimental (CIT vs Webbing & Belting Factory Ltd — 68 ITR 186 SC). Mere installation of machinery and its trial run will not amount to setting up of business. Mere manufacture of prototypes will not indicate commencement of production. Until the company reaches a stage where it is in a position to decide that a final product which could ultimately be sold in the market could be manufactured or produced by it, it will be idle formality to say that it had started manufacture or production of articles simply because trial products are prepared with a view to verify whether they can be ultimately used in the preparation or manufacture of the final products.

The judgment of the AP High Court in the Coramandel Fertilizers case is a landmark ruling on the question of setting up and commencement of business. There was no occasion for the court to go into the question of trial production. The matter was settled in favour of the Revenue even on the initial issue of setting up of business.

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