2018 (7) TMI 2369 - HC - Income Tax

Nature of receipt - interest receipt in the hands of the appellant - income from other sources OR capital receipts - HELD THAT - As decided in Bokaro Steel Ltd. 1998 (12) TMI 4 - SUPREME COURT Court held that the accepted accountancy rule for determining cost off 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 of such borrowed money can be capitalised and added to the cost of the fixed assets created as a result of such expenditure. By the same reasoning if the assessee such expenditure. By the same reasoning if the assessee receives any amounts which are inextricably linked with the process of setting up its plant and machinery such receipts will go to reduce the cost of its assets. These are receipts of a capital nature and cannot be taxed as income. Disallowing the mandatory CSR expenses claimed pursuant to the terms and conditions of the environment clearance granted by Ministry of Environment and Forest - Issues are answered in favour of the assessee and against the department. It is held that the expenses incurred are revenue expenditure and not capital expenditure.

Summary

Two principal issues were considered by the Court in this appeal arising from the Income Tax Appellate Tribunal's (ITAT) order: (i) whether the interest receipt of Rs. 12,64,01,627/- by the appellant should be treated as income from other sources or as capital receipt linked to pre-operative expenses, and (ii) whether the disallowance of mandatory Corporate Social Responsibility (CSR) expenses amounting to Rs. 95,08,197/- pursuant to environmental clearance terms was legally sustainable.

Regarding the first issue, the core legal question was the proper characterization of interest earned on borrowed funds prior to commencement of commercial operations of specified mega road projects. The appellant contended that such interest income was capital in nature and should be set off against pre-operative expenditure capitalized under "Capital Work in Progress," whereas the Revenue treated it as income from other sources, liable to tax accordingly.

The Court extensively examined the relevant legal framework and precedents, particularly the judgments of the Supreme Court and coordinate benches of the High Court. A key precedent was the decision in Pr. Commissioner of Income Tax vs. M/s. Road Infrastructure Corporation of Raj. Ltd., where the Coordinate Bench held that if borrowed funds are "inextricably linked" to the setting up of a plant or project, interest earned on such funds prior to commercial operations is capital receipt and should be capitalized against pre-operative expenses. This was distinguished from the Supreme Court's ruling in Tuticorin Alkali Chemicals and Fertilizers Ltd., which held that interest earned on surplus borrowed funds temporarily invested is taxable as income from other sources, since the assessee had discretion over the use of such interest income.

The Court noted that in the instant case, the loan agreement mandated that disbursements be deposited in a trust and retention account, strictly controlled by senior lenders, and used solely for project implementation. Therefore, the funds and the interest earned thereon were "inextricably linked" to the project and not freely disposable by the appellant. This factual matrix aligned with the reasoning in the coordinate bench decision, favoring capitalization of the interest income rather than treating it as taxable income from other sources.

The Court also considered the Revenue's argument that the appellant had spare funds parked in fixed deposits earning interest, which should be taxable as income. However, the Court found this argument unpersuasive in light of the loan agreement restrictions and the nature of the project funds. The Court relied on the Supreme Court's decision in Bokaro Steel Ltd., which emphasized that receipts directly connected or incidental to construction activities and capital structure formation are capital receipts, not income from independent sources.

Further, the Court reviewed other precedents such as Commissioner of Income Tax vs. Autokast Ltd. and Indian Oil Panipat Power Consortium Ltd., which clarified the distinction between interest income earned on surplus funds (taxable as income) and income linked to capital projects (capitalized). The Court concluded that the interest receipt in question was capital in nature and should be set off against pre-operative expenditure under "Capital Work in Progress." Thus, the ITAT erred in treating it as income from other sources.

Turning to the second issue concerning disallowance of mandatory CSR expenses pursuant to environmental clearance conditions, the Court examined whether such expenses are deductible business expenditures under the Income Tax Act. The appellant argued that the CSR expenses were incurred in compliance with statutory environmental conditions and thus were necessary for carrying on the business.

The Court referred to settled principles laid down by the Supreme Court in Sri Venkata Satyanarayana Rice Mill Contractors Co. vs. Commissioner of Income Tax, which held that the test for deductibility of business expenses is "commercial expediency" rather than mere compulsion. Payments made for the purpose of business, not constituting penalties or illegal gratification, are allowable deductions under Section 37(1) of the Income Tax Act.

Supporting this view, the Court cited decisions such as Commissioner of Income Tax vs. Rupsa Rice Mill, where contributions towards public welfare funds directly connected with business operations were held to be deductible revenue expenses. Similarly, voluntary contributions or payments made to public welfare or relief funds that benefit the business are allowable deductions, as held in Additional Commissioner of Income Tax vs. Rajasthan Spg. & Wvg. Mills Ltd..

The Court further relied on coordinate bench decisions of the Rajasthan High Court, which consistently held that expenses incurred for statutory compliance or public welfare, which have a nexus with the business and are not capital in nature, qualify as revenue expenditure deductible under the Income Tax Act. The Court observed that since the CSR expenses were mandatory under environmental clearance and aimed at fulfilling statutory obligations linked to the business, they constituted allowable revenue expenditure.

In addressing the Revenue's competing arguments, the Court noted that there was no allegation that the CSR expenses were illegal or against public policy. The payments were not penalties but compliance costs necessary for lawful business operations. The Court emphasized that disallowing such expenses would be contrary to the principle that expenses incurred for carrying on business, even if mandated by law, are deductible if they meet the test of commercial expediency.

Consequently, the Court held that the ITAT erred in disallowing the CSR expenses claimed by the appellant. The expenses were revenue in nature and deductible under the Income Tax Act.

In conclusion, the Court allowed the appeal on both issues. It held that the interest income earned on borrowed funds prior to commencement of commercial operations was capital receipt, to be set off against pre-operative expenditure capitalized under "Capital Work in Progress," and not taxable as income from other sources. Further, the mandatory CSR expenses incurred in compliance with environmental clearance conditions were allowable revenue deductions under the Income Tax Act.

Key holdings include the following verbatim excerpts elucidating the Court's reasoning:

"The interest received prior to commencement of commercial operations of the specified mega road projects will be in the nature of capital receipt and will be required to be set off against the pre-operative expenditure capitalized under the head 'Capital work in progress' and the same cannot be brought to tax under the head 'income from other sources'."

"Any contribution made by an assessee to a public welfare fund which is directly connected or related with the carrying on of the assessee's business or which results in benefit to the assessee's business has to be regarded as an allowable deduction under Section 37(1). Such a donation, whether voluntary or at the instance of the authorities concerned, when made to relief fund or a welfare fund or any other fund for the benefit of the public and with a view to secure benefit to the assessee's business, cannot be regarded as payment opposed to public policy."

These principles reinforce that income or receipts inextricably linked to capital projects are capitalized rather than taxed as income, and that business expenses incurred for statutory compliance and public welfare, meeting the test of commercial expediency, are allowable deductions.