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Capital and Revenue Expenditure

Capital Expenditure vs. Revenue Expenditure - Under the Income Tax Act

Since the Income Tax Act does not explicitly define "capital expenditure" and "revenue expenditure," we must rely on their ordinary meanings and judicial interpretations. Below are some key distinctions:

1. Acquisition of Fixed Assets vs. Routine Expenses

  • Capital Expenditure: Incurred to acquire, extend, or improve a fixed asset.
  • Revenue Expenditure: Incurred in the regular course of business as a routine operating expense.

2. Multiple Years vs. Single Year

  • Capital Expenditure: Provides benefits over multiple years.
  • Revenue Expenditure: Consumed within a single year.

3. Improvement vs. Maintenance

  • Capital Expenditure: Enhances the earning capacity of a business.
  • Revenue Expenditure: Maintains the profit-generating capacity of a business.

4. Non-Recurring vs. Recurring

  • Capital Expenditure: Typically a non-recurring outlay.
  • Revenue Expenditure: Generally a recurring expense.

5. Lump Sum vs. Periodic Payments

  • The method of payment (whether lump sum or periodic) does not necessarily determine if an expenditure is capital or revenue in nature.

6. Importance of Differentiation

When calculating taxable profits under the Income Tax Act, only revenue expenses are deductible. Hence, distinguishing between capital and revenue expenditure is crucial. The following criteria can be applied:

(i) Nature of the Asset

  • Capital Expenditure: Incurred to acquire or install a fixed asset.
  • Revenue Expenditure: Incurred for purchasing goods for resale and associated costs.

(ii) Nature of Liability

  • Capital Expenditure: Payments made to settle a capital liability.
  • Revenue Expenditure: Payments made to settle a revenue liability.

(iii) Nature of the Transaction

  • Capital Expenditure: Incurred to acquire a source of income (e.g., purchasing patents).
  • Revenue Expenditure: Incurred to generate income (e.g., staff salaries, advertising costs).

(iv) Purpose of the Transaction

  • Capital Expenditure: Spent to enhance the earning capacity of an asset.
  • Revenue Expenditure: Spent to maintain an asset in working condition.

(v) Nature of Payment in the Hands of the Payer

  • Capital Expenditure: Remains capital expenditure even if it is revenue receipt for the receiver.
  • Revenue Expenditure: Remains revenue expenditure even if it is capital receipt for the receiver.

Examples of Capital Expenditure

  • Costs for reconstructing or refurnishing business premises.
  • Payments made to deter a competitor from entering the business field.
  • Expenses related to converting business premises when switching products.
  • Litigation expenses to acquire or resolve title issues related to business assets.
  • Compensation for canceling a machinery purchase contract.
  • Payments for buying out a partner’s share in the firm.
  • Expenses incurred to maintain business reputation.

Examples of Revenue Expenditure

  • Payments for using quota rights, patents, and trademarks.
  • Payments for technical assistance and access to ongoing research.
  • Expenses for professionals on study tours abroad to gain new knowledge.
  • Costs necessary to render a newly purchased asset operational.
  • Replacement costs for parts of a plant that do not provide additional business advantages.
  • Expenses for sending employees abroad for practical training.
  • Fees paid to valuers for assessing business premises.
  • Expenses incurred in raising loans (e.g., stamp duty, registration, legal fees, brokerage).
  • Costs to oppose the nationalization of an industry.
  • Payments to secure overdraft facilities from a bank.
  • Payments to obtain monopoly rights for operating buses on a specific route.
  • Compensation to terminate an employee or managing agent for business reasons.
  • Any expenses incurred wholly, necessarily, and exclusively for business purposes.

Revenue Expenditure [Section 35(1)(i)]

All revenue expenses related to scientific research during the previous year are fully deductible. Additionally, revenue expenses for scientific research incurred during the three years preceding the start of the business are deemed to be expenses of the previous year in which the business begins and are deductible in that year.

Example

If a business begins on 15.12.2018, all revenue expenses related to scientific research incurred on or after that date will be deductible. Moreover, expenses incurred between 15.12.2015 and 14.12.2018, as certified by the prescribed authority, will be treated as expenses of the previous year 2018-19 and deductible in that year.

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