Financial Daily from THE HINDU group of publications
Wednesday, Aug 31, 2005
Industry & Economy - Income Tax
Government - Politics
Columns - Zero Base
The Commissioner of Income-Tax vs Janakiram Mills Ltd
As their debate proceeds to whether `mantriji ne jaan boojkar aisa kiya tha' and if wives have a duty to tell their husbands everything, let us read up the case that is making news: The Commissioner of Income-tax vs Janakiram Mills Ltd decided by the Madras High Court on April 29, 2005.
For, among the counsels for `appellant/petitioner/plaintiff' was Nalini Chidambaram, Senior Counsel, for Pushya Sitaraman, Standing Counsel.
So, rewind to assessment year 1986-87, during which Janakiram Mills Ltd, Tenkasi Road, Rajapalayam, replaced its `carding system' with `high production cards', by spending Rs 31.2 lakh.
The company claimed the amount as `current repairs' (under Section 31 of the Income-Tax Act), treating thus the expenditure as of `revenue' nature. But the Assessing Officer (AO) said `no'.
So, the company approached the Commissioner (Appeals) who looked into decisions in Sri Varadharaja Textiles P Ltd and Mahalakshmi Textile Mills Ltd cases and said that the costs were only for replacement of part of the textile machinery and, therefore, allowable as revenue expenditure.
Now, it was the turn of the Department to feel aggrieved and so it knocked the doors of the Income-Tax Appellate Tribunal (ITAT).
The Tribunal studied the `inspection report', verified `similar machineries installed in Indira Cotton Mills, Chennai' and followed an earlier decision `on the same point', and decided in December 1997 that the amount in question was revenue expenditure. The ITAT's reasoning was on the following lines: One, "the entire textile mill should be treated as one single plant, and each machinery therefore is only a part of it". And two, "wherever the spindlage or capacity has not increased due to the purchase of the new machinery in the place of the old one, it cannot be said that there is any enduring advantage".
Aggrieved again, the Department marched to the High Court for remedy.Why was the taxman aggrieved. The answer is that when any expenditure is allowed as revenue, profit reduces and so does tax. A capital expenditure, in contrast, adds to assets, though you can reduce your profits each year by claiming depreciation on the assets.
A common example to explain the difference between capital and revenue is that of vehicle and fuel. What you spend to buy a bike is capital expenditure, but the filling up of the fuel tank is a revenue payment.
Revenue-capital tangle has been an area of dispute between the taxman and the assessees. It was, therefore, necessary to insert an explanation to Section 31 of the I-T Act in 2003 thus: "For the removal of doubts, it is hereby declared that the amount paid on account of current repairs shall not include any expenditure in the nature of capital expenditure".
In the Janakiram case, the point for consideration before the High Court was whether the modernisation/current/repair expenditure was allowable as `revenue expenditure', as claimed by the assesses, or the replacement of cards/blow room machinery/combing machinery etc., were to be considered as `capital expenditure', as claimed by the Revenue?"
The case is important because the Revenue found that textile mills in the State were claiming expenses relating to purchase of new machinery as current repairs/revenue expenditure, even where the said purchase was as a part of modernisation programme or replacement of old machinery. The Department's argument was that the machines replaced in most of the cases were complete machinery, capable of independent operation.
Thus, speaking for the Department, Mrs Nalini Chidambaram argued that most of the earlier decisions of the High Court were on the presumption that what was replaced was a part of a machinery, not the entire machine itself. "For example, Ring Frames, which are complete spinning machines consisting of several spindles, have been erroneously assumed to be parts of machinery, and the expenditure on replacement thereof has been allowed as a revenue expenditure," she pointed out.
Replacement of worn out machinery with a new one results in `an enduring benefit', pointed out Mrs Nalini Chidambaram. "This enduring benefit would be there, regardless of whether the assessee purchases the machinery for the first time, or purchases it as a replacement of an old or worn out machine," she said. It would lead to an absurd result, said Mrs Nalini Chidambaram, if the purchase of a new machine by a first-time user were to be treated as a capital expenditure, but the purchase of the same machine by some one who already owned a similar machine were to be treated as a revenue expenditure/current repairs.
It would be wrong to treat the entire textile mill as a single plant and all the machinery therein as parts of the plant, reasoned Mrs Nalini Chidambaram, running counter to the ITAT's thinking. "Unlike continuous casting machinery in the steel industry, or certain other processes where the raw material is fed in one end and the finished product comes out at the other without any intervention in between, the textile mill, even in the case of `composite mills' consist of distinct sections such as blow room, carding, ginning, spinning, weaving and finishing," states the text of the judgment.
She drew attention to the fact that the goods are carried manually after one process to another. And that "there are several mills that do only one or some of the above activities such as carding and ginning or only spinning, or only calendaring and finishing". The machinery are all capable of independent action, and the fact that the next process is carried on by another machine would not lead to the conclusion that both machines are only parts and not complete machinery by themselves, contended Mrs Nalini Chidambaram.
What about the ITAT's observation about there being no increase in spindlage, that is, capacity?
"Although in theory the worn out machines may have an installed capacity of a certain spindlage or certain production capacity, in practice, since they are old and worn out, they would not be able to keep up the efficiency of work," she said, and I guess that applies to our netas too! Aged machines are more prone to breakdowns due to wear and tear, and so they cannot produce the same quantity and quality of goods in a stated time as new machines, that are technologically more advanced.
Therefore, it would be erroneous to argue that unless the overall production capacity is increased, any purchase of machinery would only be treated as revenue expenditure, said Nalini.
She highlighted how such a tack of thinking can adversely affect the concept of capital and revenue expenditure, even as companies replaced some items of large machinery every year, "resulting in a practically new plant in the course of two or three years".
A few interesting points that law and accounting professionals would appreciate are about Mrs Nalini Chidambaram explaining tax and disclosure. About the first, she noted how if replacement of machinery were to be treated as revenue, rather than adding to the block of assets, "the value of the block of assets would show a really low picture not in consonance with the real value of the assets".
The move by the company was to claim 100 per cent depreciation through a backdoor method, she said. "Once the concept of block of assets has been brought in by Parliament, from assessment year 1988-89, whether the mill is an integrated whole or not, whether the replacement of machines resulted in increased capacity or not will have no bearing.
When any item belonging to the block is removed, its value is reduced, and if any new item comes in its place, its value is added to the block," she elaborated.
The other technical point, about disclosure, was the difference that Mrs Nalini Chidambaram exposed between accounting and tax.
The textile mills had treated the purchase of new machinery in their balance sheet as addition to fixed assets, whereas for the purpose of income tax alone, they were claiming it as a revenue expenditure or expenditure on repairs.
"This shows that it is only for the purpose of avoiding payment of tax that the treatment is given as revenue expenditure, when it is well within the knowledge and belief of the Mills that the purchase of the machinery resulted in acquisition of new assets," she said. "While the value of fixed assets in the books of the company would be high, as it would include the value of the newly purchased machinery, the block of assets on which depreciation would be taken, would show a very low figure, as the written down value of the old machinery sold would have been removed, while the value of the new machinery purchased would not have been included."
A practice that seemed to have served well the companies, it appears, because they obtained long-term loans for the purchase of new machinery, from banks and financial institution against the security of such new machines.
Countering an argument of the mills that the Department had not appealed against earlier decisions of the High Court which were favourable to assessees, Nalini said that most of those related to the pre-block-concept days; only three cases Gitanjali Mills, Tuticorin Spinning, and L.S. Mills, pertained to the period after 1988-89, but they too were hit by the diktat of CBDT not to appeal to the Supreme Court where the tax effect was less than Rs 5 lakh. What came handy for the mills was a letter dated December 19, 2003 issued by D. Shanmuganandam, Assistant Director of SITRA or South India Textile Research Association stating that "the entire spinning mill, right from Blow Room to the Cone Winding section should be considered as a single integrated plant", and that the output from various intermediate stages of production cannot be sold or marketed and used for other purposes.
I'm sure experts would love to dissect SITRA's letter, as much as tax analysts would like to take a nostalgic dip in the many cases cited by the court, such as the one about a ginning factory converted into a cinema theatre in 1945!
But there's enough in the case to merit a whole book to be written about it, with a lighter side, though, reserved for the recent developments.
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