Written in : April 1999

One issue which troubles many new companies is the tax treatment to be adopted for incomes which arise during the period when the project is under construction. There are judgments of various courts and the Tribunal which have held differently. Quite often, new companies find themselves paying tax even before they get into business. A recent Supreme Court case deals with such issues and delivers a very sensible judgment.

Every new project has a gestation period – the period taken to construct civil works, set up plant, equipment and other infrastructure, and to be ready to go into commercial production. This is called the construction period.

Then, during construction period it may earn incomes from several sources all of which are inter-connected with the construction activity, ie, the activity of setting up of the business. What is the nature of such income?

These issues have troubled new companies quite a bit. The Supreme Court has now clarified this with exemplary reason.

If money is borrowed to set up its plant and interest is incurred (as payable) before the commencement of production, then it is natural that the interest is capitalised, ie, it is added to the cost of the assets created and is not treated as revenue expenditure. The law also gives the same treatment to such interest. Interest paid during construction is not allowed as a deduction but is capitalised on which depreciation is eventually allowed (it having become a part of the cost of the asset).

By the same reasoning, the court says, if the company 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.

Bokaro Steel Ltd, the taxpayer before the court, had given quarters for use to its contractors for use by the contractor's employees. Rent was received from the contractors.

Bokaro Steel also made certain advance to the contractors to enable them to execute large scale construction work smoothly. It charged interest on such advances.

It had also leased out some plant and machinery to the contractors from which it received hire charges.

The company had also allowed the contractors to use some stones lying in its premises for construction. It charged royalty from the contractors for excavation and use.

The questions before the Supreme Court were whether the incomes arising from these items were taxable in the hands of the company.

Regarding the first three items, the court said that the activities from which the income arose were intrinsically and inextricably connected with the construction work and the income resulting would not be treated as revenue receipts but would be treated as capital receipts which should reduce the cost of construction of the plant.

The court also held that the company had allowed its land to be utilised for excavation of stones for construction purposes. The cost of plant to the extent of such royalty should be reduced and the royalty cannot be treated as revenue income but was a capital receipt.

This is exemplary reasoning of the court and settles many a bothersome question.

The company had also invested its surplus idle funds in short term investments and earned some interest. The income from such short term investments was held to be taxable in its hands. The company did not contest this before the Supreme Court and the court said it was not called upon to examine this issue which had become final, against the taxpayer, in an earlier case of Tuticorin Alkali Chemicals and Fertilizers Ltd.

There was another important issue which the court decided. Bokaro Steel had supplied 8 locomotives to Hindustan Steel Ltd. The company had accounted for interest on such supplies as its income. However, in the very next year Hindustan Steel replaced the 8 locomotives it had received on loan to Bokaro Steel by new ones. Since the agreement got altered, Bokaro reversed its entry of income in the next year. Its Board of Directors also passed a resolution confirming the transaction.

The question was whether the interest accrued to the assessee as per its entry in the books, and as per the original agreement.

The court said that there did not result any real income to the company as its original agreement had changed ab initio¸ that is, from the very beginning. Under the altered agreement, there was no income of interest accruing to it, but a replacement of the locomotives supplied by it. The entry passed showed only hypothetical income which did not materialise and the entry was reversed in the next year.

The court said that since this entry reflected only hypothetical income which did not materialise it could not be brought to tax. Only real income can be brought to tax.

The court has again emphasised that only real income can be taxed, not notional income. This is a salutary principle which is often ignored by assessing officers and appellate authorities across the country. This case exemplifies how a sensible approach to complex business issues can lead to rational solutions.