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Chief Commissioner Of Income-Tax v. Senapathy Whitely Ltd.
Factual and Procedural Background
The question referred under section 256(1) of the Income-tax Act, 1961 concerns whether initial expenditure on construction of a building and purchase of machinery, and the later transfer of those assets to a newly formed company (Laxman Isola Ltd.) without an apparent profit motive and without transferring corresponding liability for starting the business, can be treated as expenditure incurred in the course of the assessee-company's business of promoting companies.
The assessee was a company engaged in manufacture and sale of electrical insulating press boards and multi-ply press paper. Its memorandum and articles authorised the promotion of other companies. Pursuant to that object, the assessee obtained a Government of India licence on 14 August 1973 to establish a mica paper manufacturing undertaking at Ramanagaram, Bangalore, with the intention of transferring it to the newly incorporated Laxman Isola Ltd.
The letter of intent was extended to 31 December 1976. Laxman Isola Ltd. was incorporated on 28 June 1976. Various statutory approvals were required and obtained only later: Reserve Bank permission (letter dated 9 September 1977 under the Foreign Exchange Regulation Act), and Government approval to the assessee's investment on 23 November 1977 (subject to conditions including that the investment be from internal resources and subscription before 30 May 1978). By a board resolution of Laxman Isola Ltd. on 21 December 1977, 23,430 shares were allotted to the assessee as consideration for transfer of assets.
The assessee incurred Rs. 24,83,743 on setting up the undertaking during the years 1974–1977 (amounts for buildings, technical know-how, machinery and others are recorded in the opinion). These expenditures were recorded in a separate ledger called the "Mica Project Account", later headed "Laxman Isola Ltd." in parenthesis. Prior to transfer, the assessee obtained a fresh RBI approval on 28 December 1977 to enable transfer of the factory building and other assets to the new company.
The Revenue allowed interest as business expenditure for the years 1975–76 and 1976–77, but contested similar claims for 1977–78 and 1978–79 on the ground that borrowings had funded assets which were diverted as capital of the new company. The Appellate Tribunal disagreed with the Revenue and allowed the assessee’s appeals. The reference under section 256(1) follows from that dispute.
Legal Issues Presented
- Whether the initial expenditure on the construction of the building and purchase of machinery and the subsequent transfer of these assets to Laxman Isola Ltd., without apparent profit motive and without transfer of corresponding liability, can be held to be in the course of the assessee's business of promoting companies?
Arguments of the Parties
Revenue's Arguments
- The Revenue contested the deduction of interest for 1977–78 and 1978–79 on the ground that the borrowings were employed to create assets which were subsequently diverted as the capital of the new company (i.e., the assets were not used for the assessee's own business but for another concern).
- Learned counsel for the Revenue contended that the assets for which expenditure was incurred were of an enduring nature and therefore constituted capital expenditure (this contention the court noted but did not decide further).
Assessee's / Appellate Tribunal's Position
- The assessee carried out the setting up of the mica undertaking as part of its business (authorized by its memorandum and articles), recorded the expenditures in a specific "Mica Project Account", and intended to transfer the completed undertaking to a company it promoted (Laxman Isola Ltd.).
- Even though the assessee intended eventual transfer, it was not in a fiduciary position and had no obligation to transfer the assets; had the new company not been formed or licences/approvals not been granted, the assets would have remained with the assessee and continued to be used in its business.
- The Appellate Tribunal therefore treated the use of borrowed funds for setting up the undertaking as laying out borrowed capital for the purpose of the assessee's own business, making the interest allowable as business expenditure.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| Maharaja Shri Umaid Mills Ltd. (No. 2) v. CIT, [1989] 175 ITR 72 (Rajasthan High Court) | Principle that deduction for expenditure in setting up a new venture is allowable if a legal inference can be drawn that the ventures constitute the same business (i.e., tests of interconnection/interdependence apply). | The court cited this decision for the proposition that the test to decide whether different ventures form the same business involves examining interconnection/interdependence and applied that test to conclude the mica undertaking was connected to the assessee's existing business. |
| Setabganj Sugar Mills Ltd. v. Commissioner of Income-Tax, [1961] 41 ITR 272 | The test (as explained by the Supreme Court) for determining whether different ventures form the same business — a mixed question of law and fact; principles include examining interconnection, interlacing, interdependence and unity. | Quoted and relied upon (through Maharaja Shri Umaid Mills) to support applying the interconnection test to the facts and to draw a legal inference that the new venture and the assessee's existing business were sufficiently linked. |
| Scales v. George Thompson and Co. Ltd., [1927] 13 TC 83 (Rowlatt J.) | Authority describing the "real question" as whether there was interconnection, interlacing, interdependence or unity embracing the two businesses. | Quoted as the foundational statement of the test of interconnection which the court applied in assessing whether the mica project was part of the assessee's business. |
| CIT v. P. Ganu Rao and Sons, [1990] 185 ITR 324 (Madras High Court) | Illustrates a fact-based decision where an advance by a leather manufacturing company to a HUF to construct a house could not be related to the company's manufacturing business. | The court noted this decision is entirely fact-specific and distinguished it from the present facts where the interconnection test was satisfied. |
| Empire Jute Co. Ltd. v. CIT, [1980] 124 ITR 1 (SC) | Principle that the test of "enduring benefit" is not the exclusive or sole test to determine whether an expenditure is capital or revenue in nature. | The court invoked this authority to explain that even if assets were enduring, that alone would not automatically make the expenditure capital; hence the court did not base its decision solely on the enduring nature argument advanced by the Revenue. |
| A.V. Thomas and Co. Ltd. v. CIT, [1963] 48 ITR 67 | Case dealing with an advance to purchase shares where the advance was held to be of a capital nature (an expenditure to acquire capital) and the facts involved promotion by another agency. | The court observed that the facts of A.V. Thomas were entirely different and that the decision was relied upon by Revenue's counsel (Mr. Raghavendra Rao); the opinion distinguished that case on its facts and did not treat it as applicable. |
Court's Reasoning and Analysis
The court framed its analysis largely by accepting and adopting the findings of the Appellate Tribunal and applying established principles about when separate ventures constitute the same business:
- It recorded the Appellate Tribunal's enumerated factual findings: that the assessee carried on the specified manufacturing business; that it was authorized to promote other companies; that the letter of intent for the mica undertaking was issued to the assessee; that Laxman Isola Ltd. was incorporated; that statutory requirements (including amendment of import licences and RBI approval) were completed only later; that the assessee kept a separate "Mica Project Account" and that expenditure was incurred by the assessee prior to the incorporation and prior to transfer.
- The tribunal's key factual conclusion — which the court endorsed — was that the assessee was not in a fiduciary position vis-à-vis the new company and had no obligation to transfer the assets it created. Consequently, until a transfer took place, those assets constituted part of the assessee's business.
- On that basis, the use of borrowed funds to set up the undertaking was regarded as borrowing for the assessee's own business purposes. The court cited the proposition (as stated by the Appellate Tribunal) that even where borrowed capital is used for capital expenditure, interest can be allowed as a deduction if the borrowing is for the setting up of the business.
- The court applied the interconnection test (drawing on Maharaja Shri Umaid Mills and Setabganj/Scales) and found that, in the present facts, the mica paper undertaking was interconnected with the assessee's existing manufacturing activities: the product (mica paper) could be consumed by the assessee or marketed along with its other products, and the import licence stood in the name of the assessee, indicating close linkage.
- The court distinguished factually inapposite authorities (for example, P. Ganu Rao and A.V. Thomas) and noted that the "enduring benefit" test is not conclusive (citing Empire Jute), so it did not accept Revenue's contention based solely on the enduring nature of the assets.
- Given these factual findings and legal principles, the court concluded there was no trusteeship or obligation making the expenditures anything other than expenditures incurred in the course of the assessee's own business operations.
Holding and Implications
HOLDING: The reference is answered in the affirmative and against the Revenue. The court held that the initial expenditure incurred on constructing the building and purchasing machinery, and the subsequent transfer of those assets to Laxman Isola Ltd. (under the facts described), could be regarded as expenditure in the course of the assessee's own business of promoting companies and not as expenditure diverted solely to create capital of another concern.
Implications:
- Direct effect on the parties: The court’s conclusion upholds the Appellate Tribunal’s approach and is adverse to the Revenue’s contention; the reference is answered in favour of the assessee.
- On broader implications: The court applied established tests of interconnection/interdependence (Setabganj/Scales and Maharaja Shri Umaid Mills) and reiterated that the enduring-benefit test is not the exclusive determinant (Empire Jute). The opinion distinguishes fact-specific precedents that are not apposite. The opinion does not state that it is laying down a new precedent beyond applying these existing principles to the facts at hand.
References answered accordingly.
K. Shivashankar Bhat, J.:— The following question referred to us under section 256(1) of the Income-tax Act, 1961, requires our consideration:
“Whether the initial expenditure on the construction of building and purchase of machinery and the subsequent transfer of these assets to the Laxman Isola Limited without any apparent profit motive and without the transfer of corresponding liability incurred for the starting of the business can be held to be in the course of the assessee's business of promoting companies?”
2. The assessee is a company carrying on the business of manufcture and sale of electrical insulating press boards and multi-ply press paper. Articles 16, 19 and 21 of the articles of association and the memorandum of objects of the company also authorise it to carry on the business of promoting other companies. In pursuance of that object, the assessee obtained on August 14, 1973, a licence from the Government of India for the establishment of a new industrial undertaking at Ramanagaram, Bangalore, for the manufacture of mica paper with the intention of transferring it to a newly incorporated company called “the Laxman Isola Ltd.” The letter of intent given by the Government of India on August 14, 1973, was extended up to December 31, 1976, as the as sessee was not able to complete the setting up of the undertaking. Thereafter, on June 28, 1976, the Laxman Isola Ltd. was incorporated. The assessee had to get the permission of the Chief Controller of Imports and Exports to amend the import licence in the name of the new company and it was only on November 23, 1977, that the Government approved the proposal of the assessee to invest in 37,500 equity shares of Rs. 100 each in the new company, Laxman Isola Ltd., after the Reserve Bank had given permission by letter dated September 9, 1977, under the Foreign Exchange Regulation Act. This approval was subject to the condition that the assessee shall not resort to borrowing for the proposed investment which shall be made from its own internal resources and the subscription had to be made before May 30, 1978. By a resolution of the board of Laxman Isola Ltd. passed on December 21, 1977, 23,430, shares were allotted to the assessee-company. This entire venture was made under a technical collaboration agreement between the assessee and Messrs. Swiss Insulating Works Ltd., a foreign collaboration which was approved by the Government of India. During the process of setting up of the industrial undertaking, the assessee had incurred expenditure totalling Rs. 24,83,743 during the years 1974 to 1977, thus:
On buildings For technical know-how Others including for machinery Total 1974 1,17,627 80,000 — 1,97,627 1975 4,25,262 — — 4,25,262 1976 3,43,420 — 21,000 3,13,443 6,77,863 8,86,309 80,000 3,34,443 13,00,752 1977 3,43,868 — 8,39,123 11,82,991 12,30,177 80,000 11,73,566 24,83,743
3. As and when the expenditure was incurred by the assessee, it was recorded in its own books under a separate ledger called “Mica Project Account”. After the incorporation of the new company, this account had the heading “Laxman Isola Ltd.” in parenthesis. After the undertaking had been set up and after the new company had been incorporated, the assessee had to get fresh approval from the Reserve Bank of India which was given on December 28, 1977, before it could transfer the factory building and other assets to the new company. The shares of the new company were allotted to the assessee in consideration of the transfer of these assets belonging to the assessee till then, though these assets were created by the assessee for the purpose of the new industrial undertaking. It is clear from these facts that in case the new company could not be incorporated for any reason, these assets would have continued to be with the assessee and would have been continued to be used by the assessee for its business purposes. There is no dispute that, during the years 1975–76 and 1976–77, the interest on the borrowings (borrowed for the purposes of these assets) were allowed as business expenditure of the assessee by the Revenue. But a similar claim for deduction during the years in question, i.e, 1977–78 and 1978–79, was contested by the Revenue on the ground that the borrowings were to create assets which were diverted as the capital of the new company. The Appellate Tribunal, however, did not agree with the stand taken by the Revenue and allowed the appeals filed by the assessee before it. Hence, these references.
4. The Appellate Tribunal held that, (1) the assessee is a company carrying on the business of manufacture and sale of electrical insulating press boards and multiply press paper; (2) the new undertaking started by the assessee (which is now vested in the new company called Laxman Isola Ltd.) was to manufacture mica paper; (3) the articles of association and the memorandum of association of the assessee authorise it to promote other companies; (4) the letter of intent to manufacture mica paper was given to the assessee by the Government of India on August 14, 1973, which was extended up to December 31, 1976; (5) the new company was incorporated on June 28, 1976, however, the import licence to import the requisite materials, which stood earlier in the name of the assessee, was amended on November 23, 1977, substituting the name of the new company; (6) there were other requirements under relevant statutes which were completed by the permission granted by the Reserve Bank of India, etc., and, only in December, 1977, the new company obtained the assets in question from the assessee; (7) as and when the expenditure was incurred by the assessee, it was recorded in its own books under a separate ledger called “Mica Project Account”, which was transferred to the heading “Laxman Isola Ltd.” in parenthesis after the new company was incorporated; (8) even before the new company was incorporated, the assessee had incurred expenditure for setting up an industrial undertaking which was to be eventually transferred to the new company.
5. The Appellate Tribunal, however, found that the assessee was not in a fiduciary position in relation to the new company. It had no obligation to transfer the assets brought into existence by it to the new company. The finding of the Appellate Tribunal is:
“In the circumstances, it is clear that, at the time when the assessee incurred the expenditure for setting up the undertaking called Mica Project, it constituted part of its own business though it may have had an idea of transferring it eventually to the new company being promoted by it. In the circumstances, use of the borrowed funds for meeting the expenditure for setting up that undertaking could only be regarded as laying out of the borrowed capital for the purpose of the assessee's own business. It is now well-settled that even where the borrowed capital is used for meeting the capital expenditure, the interest paid thereon should be allowed as a deduction if the borrowal is after the setting up of the business.”
6. The Appellate Tribunal was justified in concluding, from the facts and circumstances, that there was no trusteeship in respect of the setting up of the new company by the assessee, and that the expenditure incurred on the setting up of the undertaking (or the unit) to manufacture mica paper was an expenditure incurred by the assessee as part of its existing business operations. If, for any reason, the Government of India or any statutory authority refused to permit the new company to have the import licence or have the shares allotted to the petitioner in lieu of the transfer of assets, these assets would have continued with the assessee as the business assets of the assessee. Therefore, the answer to the question referred to us has to be necessarily in the affirmative.
7. In Maharaja Shri Umaid Mills Ltd. (No. 2) v. CIT, [1989] 175 ITR 72, the Rajasthan High Court had to consider whether the assessee-company which carried on business in textiles was entitled to deduction of the amounts spent by it for obtaining a survey and feasibility report regarding a polythene plant, with a view to set up a polythene plant, since polythene was necessary to manufacture packing material required for the products of the assessee. The deduction was allowable in case a legal inference can be drawn that the different ventures constituted separate businesses or, viewed together, can be said to constitute the same business. The High Court held at page 74:
“The test to be applied for deciding whether this is an allowable expenditure or not was indicated by the Supreme Court in Setabganj Sugar Mills Ltd. v. Commissioner Of Income-Tax., [1961] 41 ITR 272, as under (at page 274):
‘The question whether, on the application of the settled tests, different ventures carried on by an individual or a company form the same business is a mixed question of law and fact. Certain principles are applied to determine whether, on the facts found, a legal inference can be drawn that the different ventures constitute separate businesses or, viewed together, can be said to constitute the same business. These principles were stated by Rowlatt J. in Scales v. George Thompson and Co. Ltd., [1927] 13 TC 83, 89. The learned judge observed:
“… the real question is, was there any interconnection, any interlacing, any interdependence, any unity at all embracing those two businesses?”
The learned judge also observed that what one has to see was whether the different ventures were so interlaced and so dovetailed into each other as to make them into the same business. These principles have to be applied to the facts before a legal inference can be drawn that a particular business is composed of separate businesses, and is not the same one.’”
8. If perchance, the assets created by the assessee could not be transferred to the new company, those assets would have continued, in the instant case, with the assessee and, in all probability, the assessee would have started manufacturing the mica paper in collaboration with the foreign company, since the import licence stood in the name of the assessee. It is also clear that mica paper is a product consumable by the assessee or could be marketed along with other articles produced by the assessee and mica paper belonged to the broad group of those other articles manufactured by the assessee. The test of interconnection between the two businesses is satisfied here.
9. The decision of the Madras High Court in CIT v. P. Ganu Rao and Sons, [1990] 185 ITR 324, is based entirely on the facts of the said case. The advance made by the leather manufacturing company to a Hindu undivided family to construct a house could, in no way, be held as related to the leather manufacturing activity.
10. The contention of learned counsel for the Revenue that the assets for which expenditure was incurred were of enduring nature resulting in a capital expenditure need not be gone into here because we are concerned with the interest paid on the borrowings by a company which was already manufacturing various articles, and the proposed expenditure resulted in the expansion of the said manufacturing activity. Further, the test of enduring benefit is not an exclusive and sole test to determine whether an expenditure is in the nature of a capital or a revenue expenditure (vide Empire Jute Co. Ltd. v. CIT, [1980] 124 ITR 1 (SC) at page 10).
11. Mr. Raghavendra Rao relied heavily on the decision of the Supreme Court in A.V Thomas and Co. Ltd. v. CIT, [1963] 48 ITR 67. The facts of the said case were entirely different. It was a case of advance made to purchase certain shares. The new company was sought to be promoted by another agency. The advance was treated as a business loss by the assessee as it thought that the advance could not be recovered. The advance made was held as an expenditure incurred to acquire capital and hence the loss was in the nature of a capital expenditure. In these circumstances, the question referred to us has to be answered in the affirmative and against the Revenue.
12. References are answered accordingly.
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