Depreciation

Pre-operative expenses — Depreciation on pre-operative expenses allocated to fixed assets is allowable under s 32 since expenses were incurred for setting up of fixed assets during the trial run, as held by DelTrib in Cosmic Kitchen Pvt Ltd v ACIT — In favour of: The assessee; ITA No 5549/Del/2010: (AY 2006–2007).

Cosmic Kitchen Pvt Ltd v ACIT
ITAT BENCH 'B' NEW DELHI
ITA No. 5549/Del/2010
Assessment Year: 2006-2007
C L Sethi, JM and K G Bansal, AM

Decided on: 13 May 2011

Counsel appeared:
Shri Ajay Vohras/Gaurav Jain/Shikha Sharma, Advs. for the appellant
Shri Y Kakkar, Sr. DR for the respondent
Order
Per: K G Bansal, AM:

The only ground taken in this appeal, filed by the assessee, is that the learned CIT(A) erred in
disallowing depreciation of Rs.2,70,744/- in respect of preoperative expenses allocated to fixed assets.
It is also mentioned that he erred in holding that the expenses were revenue in nature and not linked
with installation of various assets.



2. The facts of the case are that the assessee-company filed its return on 29.11.2006 declaring loss of
Rs.30,94,980/-. The return was processed u/s 143(1) of the Income-tax Act, 1961, on 13.10.2007. A
notice u/s 143(2) dated 10.10.2007 was served on the assessee for making scrutiny assessment. It was
found that .the assessee is engaged in the business of manufacturing and trading in cakes, pastries,
biscuits, bread, other bakery products, chocolate products, confectioneries and allied foods products.
These products are directly supplied to institutional customers. It is also operating a restro named
“Choko la”.


2.1 On perusal of the accounts and notes thereto, it was found that the assessee company commenced
commercial operations from 13.10.2005. In view thereof, the assessee was requested to file the details
of pre-operative expenses. According to the details submitted, expenditure of Rs.16,93,153/- was
incurred before 13.10.2005, the details of which are as under:-



S.No. Particulars of Expenses Up to 13.10.2005

1. Admn. & General Expenses 66,829

2. Conveyance 5,604

3. Electricity, Gas & water 73,069

4. Kitchenware 12,131

5. Net Consumption of material 1,98,082

6. Occupation cost/rent 9,09,194

7. Payroll costs 4,25,169

8. Transportation charges 3,075

Total 16,93,153


2.2 As the expenses had been incurred prior to commencement of business, the assessee was
requested to state as to why the claim of depreciation of Rs.2,70,744/-, in respect of pre-operative
expenses should not be disallowed. It was submitted that the expenses have been incurred for the
purpose of setting up the assets of the company and, therefore, these have been allocated to various
assets in the ratio of the cost of the asset to the total cost. However, the Assessing Officer did not
accept this contention. It has been held that the expenses are revenue in nature and not linked to any
asset used for the purpose of business after 13.10.2005. Therefore, the deduction of depreciation on
these expenses was disallowed. The learned CIT(A) confirmed this finding by mentioning that the
assessee has not been able to substantiate that the expenses were incurred for acquisition of any fixed
asset. U/s 32 of the Act, the deduction for depreciation can be granted only in respect of specified
assets subject to the condition that the expenditure is incurred for its cost.

3. Before us, the learned counsel drew our attention towards the findings of the Assessing Officer and
the learned CIT(A). Our attention has also been drawn towards major expenses, being administrative
and general expenses of Rs.73,069/-. Net consumption of material of Rs.1,98,082/-, rent of
Rs.9,09,194/- and personnel’s salary of Rs.4,25,169/-. It is submitted that electricity, gas and water
charges, consumption of material charges, and kitchenware expenses of Rs.12,131/- were incurred in
the course of trial production. The rent is in respect of premises in which the equipments have been
set up. It was submitted before the lower authorities that prior to commencement of business on
13.10.2005, all the activities were centered around putting up various fixed assets to bring them to
working condition. Thus, the only activity carried out upto this date, was to put up the plant and other
fixed assets so that the business of manufacture of various food products may be carried out. Since
these expenses were incurred for putting up the assets, they were required to be capitalized towards
the cost. The rent was in respect of the land on which assets were installed for carrying out the
business. The expenses on electricity, gas and water were incurred for running various assets in the
construction period. Coming to the legal issue, it is submitted that depreciation u/s 32 of the Act is
allowed on actual cost of the asset, which means the actual cost to the assessee. This cost should be
construed in ordinarily commercial manner. Thus, it will include the cost incurred to bring the asset to
the running condition. It was further submitted that expenses such as legal charges and stamp duty in
the case of land, architect fees in case of building, wages and salary paid for installation of machinery
and interest on borrowed capital used for purchase of machinery upto the date of installation thereof
are capital expenses. From the above, it would transpire that any expenditure on putting up fixed asset
will amount to the cost of fixed asset. It was also submitted that AS-10 regarding “accounting for
fixed assets” issued by the ICAI specifies the components of cost of a fixed asset. Thus, the purchase
price of an asset includes import duties, levies, non-refundable taxes and any other cost directly
attributable to the asset for bringing it to the working condition. The examples given in AS-10 are site
preparation, initially delivery and handling cost, installation cost, such as laying foundations, and
professional fees for architects and engineers. The preliminary project expenditure, indirect
expenditure relating to construction and other indirect expenditure not related to construction have
been included in the cost of the asset. Accordingly, it is argued that the expenses are required to be
capitalized and that the allocation has been made by the assessee on a reasonable basis in the ratio of
cost of the asset to the total cost.

3.1 In reply, the learned DR referred to the findings of the Assessing Officer and the learned CIT(A)
that all the expenses are revenue in nature. The assessee has not been able to bring any evidence on
record that any of the expenditure was related to a particular asset. In fact, the expenditure has been
allocated to the assets on a proportionate basis. The assessee has also been dealing in soft drinks in the
pre-commencement period. Therefore, it is argued that the expenses cannot be allowed to be
capitalized.

3.2 In the rejoinder, the learned counsel submitted that the assessee is not dealing in software. It is
manufacturing various food items and selling them institutional customers.

4. We have considered the facts of the case and submissions made before us. The facts are that the
assessee has incurred expenditure of Rs.16,93,153/- in the pre- commencement period, which has
been debited under 8 heads, the details of which have already been furnished. Prima facie all the
expenses are revenue in nature. The assessee has not been able to link any of the expenditure with a
particular fixed asset. However, its case is that in this period, it was only engaged in putting up fixed
assets on rented land. Since the expenses were incurred for setting up fixed asset, they had to be
capitalized. The assessee has capitalized the expenses in the ratio of the cost of the asset to the total
cost, which is a reasonable basis. On the other hand, the of the learned DR is that in absence of any
corelation of any expenditure with any fixed assets, the expenses which are of revenue in nature,
cannot be capitalized.

4.1 Section 43(1) defines “actual cost” to mean actual cost of the asset to the assessee, reduced by that
portion of the cost thereof, if any, as has been met directly or indirectly by any other person or
authority.

4.2 In the case of CIT v Food Specialties Limited, (1982) 136 ITR 203 (Delhi), it has been mentioned
that it seems that the Tribunal was not wrong in holding that the expenditure of test runs was a capital
expenditure. Therefore, expenses involved in purchase of milk and determining that the factory was in
proper working condition and making adjustment does not seem to be anything more than steps in
setting up and finalization of the factory, which is the capital asset. After tests have been carried out, it
can be said that the factory had been set up and it is ready for commercial production. Therefore, the
expenses can be said to have been incurred as cost of the plant and machinery. When comparing the
facts of the case, it can be said that the expenses incurred on kitchenware and consumption of material
during trial run are to be capitalized towards the cost of plant and machinery.

4.3 In the case of Challapalli Sugars Limited v CIT (1975) 98 ITR 167 (Supreme Court), it has been
held that interest of Rs.2,38,614/- incurred on borrowed capital for purchase of plant and machinery,
accruing to the date of installation of the machinery is a capital expenditure, on which depreciation
and development rebate are admissible. From this decision it can be said that if an expenditure which
is otherwise of revenue in nature, has been incurred towards acquisition of a capital asset, it will be
the cost of the asset provided it has been incurred upto the date of installation of the asset. However, it
is also clear that there should a direct nexus between expenditure and putting up of the asset, which is
missing in this case. Therefore, the ratio of this decision does not advance the case of the assessee.

4.4 In the case of CIT v Lucas-TVS Limited ( No.2), (1977) 110 ITR 346, one of the questions before
the court was – whether, on the facts and in the circumstances of the case, it has been rightly held that
the sum of Rs.1,30,768/- representing indirect expenditure on salaries, rent, lighting, etc. and allocated
to various assets formed part of the capital asset for the eligibility of depreciation allowance and in
relation to the cost of the machinery was eligible for development rebate also? The facts of the case
are that the assessee-company acquired land near Madras and erected buildings, plant and machinery
etc. It also took on lease adjoining land for its use from integral coach factory. After completing the
work of erecting the factory to certain stage, the production commenced on 01.12.1962. The accounts
of the assessee were closed for the first time on 30.11.1962, during which it incurred total expenditure
of Rs.5,86,509/- relating to salaries, rent, lighting etc. This expenditure was capitalized and allocated
to the capital assets in the ratio of direct cost of the assets. Depreciation allowance and development
rebate were claimed. The Assessing Officer held that the expenses amounting to Rs.1,30,768/- were in
no way connected with installation of assets. Therefore, he excluded this amount and recomputed the
cost of assets. The Hon’ble Court mentioned that the question is covered by the decision of Supreme
Court in the case of Challapalli Sugars Limited v CIT (supra) and CIT v Hindustan Petroleum
Corporation, (1975) 98 ITR 167, in which it has been held that accepted accountancy rule for
determining cost of fixed assets is to include of expenditure necessary to bring such assets into
existence and to put them in working condition. Therefore, the question was decided in favour of the
assessee and against the revenue. Having considered the facts of the case, we are of the view that they
are similar and, therefore, the ratio of this case is applicable. As the aforesaid decision directly covers
the issue at hand, we do not think it necessary to go into the case of Sangroor Vanaspati Limited v
CIT (2007) 288 ITR 222 (Punjab & Haryana).

4.5 In a nutshell, it is held that the expenses incurred by the assessee are required to be capitalized in
the light of the decision in the case of Food Specialties Limited and Lucas-TVS Limited (no.2) (supra).
We are also of the view that the proportionate method employed by the assessee is fair and
reasonable.

5. In result, the appeal is allowed.