1. Capital Expenses Vs. Revenue Expenses – under the ‘Income Tax Act.’
For computing profits of a business taxable under this Act, only revenue expenses are allowed to be deducted. Hence it becomes essential to distinguish a revenue expenditure from a capital expenditure. The following tests can be applied for this purpose :
(i) Nature of the assets. Any expenditure incurred to acquire a fixed asset or in connection with installation of fixed asset is capital expenditure.
Any expenditure incurred as price of goods purchased for resale along with other necessary expenses incurred in connection with such purchase are revenue expenses.
(ii) Nature of liability. A payment made by a person to discharge a capital liability is a capital expenditure.
An expenditure incurred to discharge a revenue liability is revenue expenditure, e.g., amount paid to a contractor for cancellation of contract to construct a factory building is capital expenditure whereas amount paid by a person—with whom he has entered into contract for supply of goods for a period of 5 years—but he fails to supply goods after 3 years, the compensation will be a revenue expenditure as it is to discharge the revenue liability.
(iii) Nature of transaction. If an expenditure is incurred to acquire a source of income, it is capital expenditure, e.g., purchase of patents to produce picture tubes of T.V. sets.
An expenditure incurred to earn an income is revenue expenditure, e.g., salary of the staff, advertisement expenses, etc.
(iv) Purpose of transaction. If the amount is spent on increasing the earning capacity of an asset, it is capital expenditure, e.g., expenditure incurred for fitting new windows of factory building.
Any expenditure incurred on keeping an asset in running condition is revenue expenditure, e.g., amount spent on protection of fixed assets which have already been acquired.
(v) Nature of payment in the hands of payer. If an expenditure is incurred by an assessee as a capital expenditure, it will remain as capital expenditure even if the amount may be revenue receipt in the hands of receiver, e.g., purchase of motor car by a businessman is capital expenditure in his hands although it is revenue receipt in the hands of car dealer. Similarly, if the nature of payment in the hands of payer is of revenue nature, it will be a revenue expenditure even if it is capital receipt in the hands of receiver.
- Cost of reconstructing, refurnishing, etc. of a business building.
- Payment made by the assessee with a view to keeping his competitor out of his field of business.
- Expenditure incurred in converting business premises when switching over from manufacture of one product to another.
- Expenditure on litigation in connection with acquiring or curing a defect in assessee’ s title to the assets of the business.
- Compensation paid for cancellation of contract for the purchase of machinery.
- Price paid for the purchase of partner’s share in the firm.
- Expenditure incurred on the maintenance of business reputation.
- Payments made for use of quota rights, or for use of patents and trade marks.
- Payment made for technical assistance and access to the fruits of continuing research [C.I. T. v. Ciba of India Ltd. (1968) 69 1. T.R. 692 (S. C.)].
- Expenditure incurred by professionals on study tour abroad to acquire latest knowledge [Dr. Vadamalayan v. C.I. T. (1960) 40 I. T.R. 50].
- Any expenditure necessary at the time of purchase to render the asset so purchased, serviceable, will be added to the initial cost as capital expenditure. But any expenditure on the replacement of part of a plant which does not bring any additional advantage to the business of assessee is revenue expenditure [C.I. T. v. Shri Rama Sugar Mills Ltd. (1952) 91 1. T.R. 191].
- Expenditure incurred to send employees abroad for practical training in the field of the business of the assessee.
- Expenditure incurred by way of fee paid to valuer for assessing the business premises.
- Expenditure incurred in raising loans, e.g., stamp duty, registration and legal fees, brokerage etc.
- Expenditure to oppose threatened nationalization of the industry.
- Expenditure incurred to secure overdraft facilities from a bank.
- Payment to the government to obtain monopoly to run buses on a route.
- Compensation or other payment made to get rid of a servant or a managing agent in the interest of the business.
- Any such expenditure incurred wholly, totally, necessarily for the business.
2. Capital Receipts vs Revenue Receipts – under the ‘Income Tax Act.’
The Capital Receipts are to be charged to tax under the head “Capital Gains” and Revenue Receipts are Taxable under other heads, it is of vital importance to understand which receipt is a capital receipt and which one is a revenue receipt.
A. Immaterial Considerations
In deciding whether a particular receipt is of a capital or revenue type, the following considerations are considered to be immaterial and not going to decide or change the character or nature of the receipt.
- Receipt in lump sum or in Instalments. Whether any income is received in lump sum or in instalments, it will not make any difference as regards its nature, e.g., an employee is to get a salary of 1,000 p.m. Instead of this he enters into an agreement to get a sum of 36,000 in lump sum to serve for a period of three years. The receipt where it is monthly remuneration or lump sum for 3 years is a revenue receipt. It has been decided in so many court cases that a lump sum receipt may be an item of revenue nature and an annual receipt recurring over few years may be a capital receipt. Thus, whether a receipt is a periodic receipt or a single receipt is immaterial for the purposes of determining its nature. [Rajah Manyain Meenak and Shamma v. C.I. T. (1956) 30 1. T.R. 286].
- Nature of receipt in the hands of recipient. Whether a receipt is capital or revenue will be determined in the hands of the persons receiving such income. No attention will be paid towards the source from which the amount is coming. Salary even if paid out of capital by a new business will be it revenue receipt in the hands of employee.
- Magnitude of receipt. The magnitude of the receipt, whether big or small, cannot decide the nature of the receipt although the size of a receipt in a transaction is not an entirely irrelevant consideration. A receipt of 10,000 may be of revenue nature whereas a receipt of only ‘ 1,000 may be a capital receipt. Supreme Court has ruled in a case Divencha v. C.I. T. (48 1. T.R. 222), that the magnitude of a receipt is immaterial for the purpose of determining its nature.
- Name given by parties and treatment in books of accounts. What name the recipient or payer of the receipt has given in the books of accounts or with what name he has called a particular transaction, all such considerations are immaterial to decide the nature of the receipt. A capital payment by a dealer may be a revenue receipt in the hands of the recipient. The character of the receipt shall be decided by considerations other than by what name the parties call it. [Divencha v. C.I. T.]. The nature of the receipt will be determined in the hands of the person receiving such income.
- Payment made out of capital. No attention will be paid towards the source from which amount is coming. Salary even paid out of capital by a new business will be a revenue receipt in the hands of the employee. It was also decided in a case that if a receipt is made out of capital, the receipt may also be a capital receipt. If a recipient is beneficially entitled not only to the income but also to the capital, payments given to him by his trustees out of the corpus would be capital receipts. [Brodie’s Trustees v. I.R. 25 T.C. 13, 16].
- Time of receipt. The nature of the receipt has to be determined at the time when it is received and not afterwards when it has been appropriated by the recipient.
- Quality of receipt. Whether the income is received voluntarily or under a legal obligation, it will not make any difference as regards its nature.
B. Distinguishing Tests
It is very difficult to draw a line of demarcation between capital receipts and revenue receipts. Even the courts have found it difficult to lay down some points of distinction on the basis of which a capital receipt may be distinguished from a revenue receipt. Some tests, however, can be applied in particular cases. These tests are
On the basis of nature of assets. If a receipt is referable to fixed asset, it is capital receipt and if it is referable to circulating asset it is revenue receipt.
Fixed asset is that with the help of which owner earns profits by keeping it in his possession, e.g., plant, machinery, building or factory, etc.
Circulating asset is that with the help of which owners earn profit by parting with it and letting others to become its owner, e.g., stock-in-trade.
Circulating asset is asset which is turned over and while being turned over yields profit or loss whereas fixed asset is one on which the owner earns profit by keeping it in his own possession.
Profit on the sale of motor car used in business by an assessee is capital receipt whereas the profit earned by an automobile dealer, dealing in cars, by selling a car is his revenue receipt.
Termination of source of income. Any sum received in compensation for the termination of source of income is capital receipt, e.g., compensation received by an employee from its employer on termination of his services is capital receipt.
Amount received in substitution of income. Any sum received in substitution of income is revenue receipt, e.g., ‘A’ company purchased the right to produce a film from its earlier producer with the condition that no other producer will be given these rights. Afterwards it is found that the rights for producing this film had already been sold. The ‘A’ company claimed damages and was awarded 40,000. It was held that damages received are the compensation for the profits which were to be earned. Hence this is revenue receipt.
Compensation received on termination of lease. Where a sum is received as compensation for termination of a lease, it is capital receipt because it is termination of source of income.
Compensation on surrender of a right. Any amount received as compensation on surrendering a right is capital receipt whereas any amount received for loss of future income is a revenue receipt. An author gives up his right to publish a book and receives 1,00,000 as compensation. It is capital receipt but if he receives it as advance royalty for 5 years it is revenue receipt.
Tests as to the purpose of keeping an article. If a person purchases a piece of sculpture to keep as decoration piece in his house, if sold later on, will bring causal receipt but if the same sculpture is sold by an art dealer it will be his revenue receipt.
If an article is acquired for the purpose of trade, the profit arising from it is revenue receipt.
C. Capital Receipts
The followings are some important examples of capital receipts decided by courts
- Salami or Nazrana received for grant of permanent lease.
- Compensation received for loss of right to future remuneration.
- Compensation received from the employer for loss of employment due to premature termination of service.
- Price received on sale of know-how.
- Damages received by an employee who is wrongly dismissed or a payment received by an employee in lieu of notice.
- Amount received by the assessee for digging and removing earth from his land for brick- making.
- Contribution received by electric supply company from consumers for installation of service lines (excess of amount over cost of installation).
D. Revenue Receipts
- Lump sum royalty received in advance.
- A “pugree” received by the owner of the house property from tenant.
- Damages awarded by a court to a company for breach of contract by another company.
- A passenger is injured in a railway accident and is temporarily disabled thus losing income for a short period. Any receipt as compensation shall be a revenue receipt.
- But if the passenger is permanently disabled, the compensation received would have been a capital receipt.
3. Revenue Losses Vs. Capital Losses – under the ‘Income Tax Act.’
Distinction has to be made between revenue losses and capital losses of the business because under the provisions of this Act capital losses are dealt with under the Chapter “capital gains” whereas revenue losses are treated as business losses and as such are treated under the head “Profits and gains of business or profession”.
Distinction has to be made between revenue losses and capital losses of the business because under the provisions of this Act, capital losses can be set off against the income from capital gains only, whereas the revenue losses are business losses and as such can be set off against any other income of the assessee.
Ordinarily a revenue loss is one which a business sustains by sale of goods of the business or by destruction of stock-in-trade or non-recovery of any amount due from the persons who were to pay the amount.
Whereas, the capital loss is one which is related to some capital asset of the business.
It is very difficult to distinguish between a capital loss and a revenue loss on the basis of certain principles. On the basis of court judgements, following decisions have become distinguishing points
- Loss due to sale of assets. Where there is loss on selling a capital asset, it is a capital loss whereas any loss incurred during the sale of stock-in-trade is a revenue loss.
- Loss due to embezzlement. Where there is embezzlement done by an employee and this causes loss to the business, it is of revenue nature.
- Loss due to withdrawal of money from bank. Once the amount is deposited in bank and then it is withdrawn by an employee and is misappropriated, it is capital loss.
- Loss due to Liquidation of Company : Amount deposited by a person with manufacturing industry to get its agency and lost due to company being liquidated is a Capital Loss..
- Loss due to Theft by an employee. : Loss occurring due to theft or embezzlement or misappropriation committed by an employee is revenue loss.