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Income and expenses of pre-commencement period
May, 27th 2008

Before a business entity commences its operations, funds may be temporarily parked in short-term deposits with a view to earn interest. At the same time, certain revenue expenses need to be incurred, which are not allowed to be deducted prior to the commencement of business. Specified expenses covered under section 35-D of the Income-tax Act "the Act", 1961 are permitted to be amortised over a period of five years from the year in which the business is commenced.

For a new project, monies may be brought in by promoters and raised by way of loans. An interesting issue, which arises for determination is whether the interest payable on the loans received would be deductible under section 57 of the Act against the interest earned on the temporary parking of surplus funds.

In CIT v Karnataka Power Corporation (247 ITR 268), it was held by the apex Court that interest receipts/hire charges received during pre-production period is on a capital account. In Tuticorin Alkali Chemicals and Fertilizers Ltd v CIT (227 ITR 172), the Supreme Court considered the investment of borrowed funds prior to commencement of business and held that the interest earnable was taxable.

In CIT v Bokaro Steel Ltd (236 ITR 315), a government company, which during the period of construction of the plant had advanced monies to contractors on which it was earning interest, received rent from quarters let out to employees. It also received hire charges on plant let out to contractors and received royalty on stones removed from its land.

The Supreme Court considered all these activities to be intricately connected with the construction activity and accordingly held that interest received, rent received, hire charges and royalty, etc, would be reduced from the cost of the assets. Such receipts would not be treated as income. A similar view was expressed by the Supreme Court in CIT v Kamal Co-operative Sugar Mills Ltd (243 ITR 2). An identical view was also taken by the Supreme Court in Bongaigaon Refinery and Petrochemicals Ltd v CIT (251 ITR 329) and CIT v Karnataka Power Corporation (247 ITR 268).

This point was considered by the Madras High Court in CIT v VGR Foundations (298 ITR 132). The facts in this case were that the assessee was a partnership firm engaged in the real estate business. For assessment years 1997-98 and 1998-99, a survey under section 133-A of the Act was conducted and notices under section 148 were issued.

The assessee filed "nil" returns of income and also filed letters stating that the returns filed vide acknowledgment No 8869, dated February 14, 2000, for the assessment year 1997-98 and acknowledgment No 8871, dated February 14, 2000, for the assessment year 1998-99, have to be treated as the returns in response to the notices issued under section 148 of the Act. Further, notices under section 143(2) were issued on November 20, 2001. The assessing officer noticed that the statements filed along with the returns of income revealed that the assessee had incurred expenses prior to commencement of business and the assessee had also earned interest income on fixed deposits with the bank. Such income had been set off against the expenses.

The assessing officer was of the view that the interest received on short-term deposits in the bank during the pre-production stage was assessable as income from other sources. Aggrieved by the orders, the assessee filed appeals to the commissioner of income tax (appeals). The commissioner dismissed the appeals and confirmed the orders of the assessing officer. Aggrieved, the assessee filed appeals to the income tax appellate tribunal. The tribunal allowed the assessees appeals and set aside the orders of the commissioner of income tax (appeals).

Counsel appearing for the revenue submitted before the Madras High Court that the assessee had set off interest earned, prior to the commencement of the business operation, against the expenses. The assessee was wrong in setting off the interest prior to the commencement of the business operation, against the expenses. The interest income earned prior to the commencement of the business has to be assessed under the head income from other sources. Hence, the assessing officer was right in assessing the interest income under the head "income from other sources" and not allowing expenses as a deduction.

The income tax appellate tribunal held that in light of the Supreme Court decision in Tuticorin Alkali Chemicals and Fetilizers Ltd v CIT (227 ITR 172), it is only in the event of interest earned out of deposits made from borrowed funds that it would be in the nature of income. Share application monies do not fall in the category of borrowed funds and do not involve payment of interest. In effect, share application monies, etc, are gathered for being used in setting up of an industrial unit, purchase of assets, etc.

Till such time the money is required for disbursement, the money had to be kept in deposit with a bank. Keeping the money in a current account would not yield any interest income.

Therefore, during the period of construction the monies were kept in deposits with the bank. In these circumstances in the light of the Supreme Court decisions in the cases of Bokaro Steel Ltd, Karnal Co-operative Sugar Mills Ltd, and Karnataka Power Corporation, the claim of the assessee was reasonable and had to be accepted.

The high court held that the tribunal allowed the claim of the assessee by following its own earlier order and had rightly come to the conclusion that interest on monies borrowed for the period prior to the commencement of business could be allowed as deduction from the interest under section 57, while computing income from other sources in respect of the interest earned.

The aforesaid decision would set at rest the controversy on this subject. While the tax department has the right to appeal to the Supreme Court, the court is likely to uphold the high court's decision, which has relied on the earlier decisions of the Supreme Court on this very point.

HP Ranina
The author is advocate, Supreme Court...

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